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The Failure to Forecast the Great Recession
Simon Potter
November 25, 2011

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Experience shows that what happens is always the thing against which one has not made provision in advance.
– John Maynard Keynes¹

Our best plan is to plan for constant change and the potential for instability, and to recognize that the threats will constantly be changing in ways we cannot predict or fully understand.
– Timothy Geithner²

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The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession. In this post, I examine the performance of the forecasts produced by the economic research staff of the Federal Reserve Bank of New York (New York Fed) over the period 2007-10 and consider some of the reasons why we, like most private sector forecasters, failed to predict the Great Recession. This spreadsheet contains staff forecasts, the outcomes, and a standard measure of private sector forecasts—the Blue Chip consensus. In addition, staff material prepared for bi-annual meetings of the New York Fed Economic Advisory Panel provide some further insights into the evolution of the staff outlook.

The staff forecasts of real activity (unemployment and real GDP growth) for 2008-09 had unusually large forecast errors relative to the forecasts’ historical performance, while the forecasts for inflation were in line with past performance. Moreover, although the risks to the staff outlook were to the downside throughout this period, it wasn’t until fall 2008 that a recession as deep as the Great Recession was given more than 15 percent weight in the staff assessment.

How Bad Were the Forecasts for Real Activity?

Economic forecasters never expect to predict precisely. One way of measuring the accuracy of their forecasts is against previous forecast errors. When judged by forecast error performance metrics from the macroeconomic quiescent period that many economists have labeled the Great Moderation, the New York Fed research staff forecasts, as well as most private sector forecasts for real activity before the Great Recession, look unusually far off the mark.

One source for such metrics is a paper by Reifschneider and Tulip (2007). They analyzed the forecast error performance of a range of public and private forecasters over 1986 to 2006 (that is, roughly the period that most economists associate with the Great Moderation in the United States).

On the basis of their analysis, one could have expected that an October 2007 forecast of real GDP growth for 2008 would be within 1.3 percentage points of the actual outcome 70 percent of the time. The New York Fed staff forecast at that time was for growth of 2.6 percent in 2008. Based on the forecast of 2.6 percent and the size of forecast errors over the Great Moderation period, one would have expected that 70 percent of the time, actual growth would be within the 1.3 to 3.9 percent range. The current estimate of actual growth in 2008 is -3.3 percent, indicating that our forecast was off by 5.9 percentage points.

Using a similar approach to Reifschneider and Tulip but including forecast errors for 2007, one would have expected that 70 percent of the time the unemployment rate in the fourth quarter of 2009 should have been within 0.7 percentage point of a forecast made in April 2008. The actual forecast error was 4.4 percentage points, equivalent to an unexpected increase of over 6 million in the number of unemployed workers. Under the erroneous assumption that the 70 percent projection error band was based on a normal distribution, this would have been a 6 standard deviation error, a very unlikely occurrence indeed.

Did We Calibrate the Risks to the Forecast Appropriately?

Of course, there is much more to forecasting than the point forecasts reported in the spreadsheet. In particular, it is crucial to assess the uncertainty and risks around any point forecast.

Throughout this period, the uncertainty and downside risks assessed around our point forecast were substantial relative to economic fluctuations in the Great Moderation. One way of gauging the appropriate calibration of downside risk is to measure the depth of the implied recession if the risks were realized.

The chart below does this by considering the probability distribution of the four consecutive quarters with the lowest GDP growth in a recession. It presents results based on the staff outlook in April 2008 and November 2008. The depth of the mild recessions shown in the chart was typical of the type of recessions expected during the Great Moderation. The actual depth of the 2007-09 recession as gauged by this metric is currently estimated to be 5 percent. As the chart shows, it was only by November 2008 that the probability of the actual outcome was above 15 percent.

Upon seeing this type of calculation, Robert Barro, a Harvard professor and member of the New York Fed Economic Advisory Panel, noted that the decline in real stock market values in the United States was similar to that observed in countries experiencing depressions. Taking this relationship into account in the calibration of the downside risks produced about a 50/50 chance of the currently observed depth of the Great Recession (see the March 2009 Wall Street Journal op-ed article by Barro for his assessment of the probability of a depression).

Recent Forecast Performance

In contrast, the New York Fed staff forecasts for 2010 made in 2009 and early 2010 are quite accurate (under the assumption of no major revisions to the estimates of GDP growth in 2010). This accuracy, however, has not been sustained through 2011. As widely discussed by a number of Federal Reserve officials, the level of real activity in 2011 has been disappointing relative to expectations. This shortfall is evident in the chart below, which compares forecasts for GDP growth in 2011 and 2012 produced in April and October 2011. However, this chart also depicts the uncertainty and risks around the staff forecast as of April 2011. Given the uncertainty around the April forecast, the subsequent changes to the outlook are not very surprising. On the other hand, near-term downside risks to this forecast were low compared to other forecasts produced in the last four years, so the direction of the change was more surprising.

Why Did We Fail to Forecast the Great Recession?

The quotations from Keynes and Geithner at the start of this post capture the importance of constantly striving to ensure that policy is robust to unexpected events. As explained in much of the recent work of the 2011 Nobel Prize–winning economist Tom Sargent, the unexpected events for which policymakers need to make provision have the characteristic of being the most likely unlikely bad event. The collapse in housing prices and its propagation to the economy certainly fit this description.

A leading example of how effective a robust approach to policymaking can be is the 2009 Supervisory Capital Assessment Program. In this program, large U.S. banks were evaluated against a capital standard under the assumption of a longer and deeper recession than contemplated in the prevailing consensus estimate. The idea was that if banks had sufficient capital to continue performing their intermediation function under this more adverse scenario, the scenario was less likely to occur.

Indeed, in the period leading up to the financial crisis, analysts who were suspicious of the stability of the Great Moderation, such as Nouriel Roubini, offered assessments that proved to be significantly more accurate than the point forecasts of New York Fed research staff or most professional forecasters in gauging the potential for unlikely bad outcomes. On a more positive note, if one compares the downside risk in the New York Fed research staff outlook with that of the Survey of Professional Forecasters (see the chart below from April 2008), there is some evidence that we had a more sober assessment of the risk of a severe downturn than did private sector forecasters.

Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out:

1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff report by Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008. Eventually, by building on the insights of Adrian and Shin (2008), we gained a better grasp of the power of these feedback loops.

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants:

Longer stretches of economic growth imply greater leverage and complacency and thus, greater financial problems when recessions do occur.
–William Dudley and Edward McKelvey³

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¹Letter to Jacob Viner, June 9, 1943, Collected Writings of John Maynard Keynes, ed. Donald Moggridge, vol. 25. London: Macmillan, 1980.

²Letter from the Chair, Financial Stability Oversight Council Annual Report.

³The Brave New Business Cycle: No Recession in Sight, Goldman Sachs Economic Research Group, January 1997.

The babysitter that oversaw the Eurozone over the past decade, the one that let them eat all the candy they wanted, watch as much TV as they could and stay up way past their bedtime is about to be fired and a strict taskmaster is about to be hired. Tough fiscal oversight is about to become reality in Europe and many in the Euro region hope that the good behavior that may follow will be enough for the ECB to put aside their prudent central bank hats and put on their Federal Reserve money printing ones. The WSJ reports today that while it isn’t clear how the ECB would respond to such a fiscal pact in terms of the non sterilized purchases of European bonds, “at least some ECB officials are open to such a tacit bargain with governments, according to people familiar with the matter.” German officials though are still not open to this as their Finance Minister said such talk comes from “those countries that have to sort out their budget problems and chose to misunderstand that they have to make more efforts.” Either way, while further ECB involvement is certainly a fix markets would love, it only treats the symptoms of the debt disease. Elsewhere, the story that the IMF will lend a massive amount of money to Italy has been denied and European Finance Ministers will meet tomorrow with the EFSF being the main focus. The EFSF insuring up to 20-30% of new issuance seems to be the talk and a smaller leveraging than originally hoped for. Similar to the Jos. A. Bank one day only sales we get bombarded with on tv everyday, the Italian Banking Association is promoting “BTP-Day” today to encourage individuals to buy Italian bonds by waiving fees to do so. They will have another “BTP-Day” in a few weeks.

If its the Monday after Black Friday, then its national hype the fabricated data day!

Every year around this time, we get a series of loose reports coincident with Black Friday and the holiday weekend. Each year, they are wildly optimistic. And like clockwork, the media idiotically repeats these trade organizations spin like its gospel. When the data finally comes in, we learn that the early reports were pure hokum, put out by trade groups to create shopping hype. (Yes, the Media ALWAYS screws the pooch big time on this one, with the occasional exception).

Let’s start with this whopper from an utterly breathless press release from the National Retail Federation:

“U.S. retail sales during Thanksgiving weekend climbed 16 percent to a record as shoppers flocked to stores earlier and spent more, according to the National Retail Federation.

Sales totaled $52.4 billion, and the average shopper spent $398.62 during the holiday weekend, up from $365.34 a year earlier, the Washington-based trade group said in a statement today, citing a survey conducted by BIGresearch. More than a third of that — an average of $150.53 — was spent online.”

No, retail sales did not climb 16%. Surveys where people forecast their own future spending are, as we have seen repeatedly in the past, pretty much worthless.

We actually have no idea just yet as to whether, and exactly how much, sales climbed. The data simply is not in yet. The most you can accurately say is according to some foot traffic measurements, more people appeared to be in stores on Black Friday 2011 than in 2010.

Another absurd example: Does any one actually believe “nearly one-quarter (24.4%) of Black Friday shoppers were at the stores by midnight on Black Friday”? Perhaps the NRF competing with the NAR for title of most ridiculous trade group.

Next up is ShopperTrak, who claimed a 6.6% gain in sales:

“Shoppers packed stores and spent money in record numbers on Black Friday, early surveys show, a phenomenon that analysts call a hopeful sign for the U.S economy after months of up-and-down consumer spending.

Black Friday sales were up 6.6 percent over last year and foot traffic in stores was up 5.1 percent, according to ShopperTrak, a Chicago-based research firm. The year-to-year spending increase was the greatest since 2007, the firm reported . . .”

What is the basis of that 6.6% gain? ShopperTrak “uses equipment installed in stores to measure traffic.” But that does not measure changes in window shoppers vs buyers from year to year, how much money and or credit people have, how large their holiday budgets are, or how much they are willing to spend. It is a very poor system for forecasting actual sales.

The fact that NRF and ShopperTrak are so widely disparate confirms for us at least one of their methodologies are suspect. In my opinion, both are mostly meaningless.

Here is my challenge to the CEOs of the National Retail Federation and ShopperTrak: $1,000 to the charity of the winners choice that your forecasts for Black Friday, the Thanksgiving weekend and the entire holiday shopping season are wildly off. I bet you your forecasts miss the mark by at least 10%-20% (though I believe its closer to 40-50%).

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Previously:

More To Holiday Sales Than A Few Phone Calls (November 28th, 2005)

There They Go Again: NRF Redux (July 28th, 2006)

More Bad Data from the NRF? (November 2006)

Repeat After Me: Spending Surveys Are Meaningless (October 2007)

How Good Were Holiday Sales Really? (January 10th, 2008)

Spinning Black Friday Retail Sales (December 1st, 2008)

Entering the Holiday Shopping Season (Beware Surveys!) (October 28th, 2009)

We Don’t Know How Black Friday Sales Were Yet (November 28th, 2009)

In Stock! Bad Holiday Sales Forecasts (November 30th, 2009)

More trading humor from The Dopey Cowboy:
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From Ron George, we get this update on disclosures and the net result of Systemic Regulatory Failure:

YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION PERMITS YOU TO PARTICIPATE IN THE UNITED STATES MARKETS THROUGH A REGULATED FUTURES COMMISSION MERCHANT. IN SO DOING, YOU SHOULD BE AWARE THAT A FUTURES COMMISSION MERCHANT (FCM), REGULATED BY EITHER THE NATIONAL FUTURES ASSOCIATION (NFA), THE COMMODITIES FUTURES TRADING COMMISSION (CFTC) OR THROUGH A SELF-REGULATED ORGANIZATION (SRO) SUCH AS THE CME, ALLOWS FOR THE CRIMINAL THEFT OF YOUR MONEY WITH NO RECOURSE. RESTRICTIONS ON REDEMPTIONS OF YOUR FUNDS FROM A FCM MAY AFFECT YOUR ABILITY TO WITHDRAW YOUR FUNDS, MANAGE ANY OPEN POSITIONS, INITIATE HEDGE OR SPECULATIVE POSITIONS RESPONSIVE TO CHANGING ECONOMIC CONDITIONS RESULTING IN ANY LOSS OF OPPORTUNITY, OR THE REDUCTION OF ECONOMIC EXPOSURE, IS COMPLETELY RANDOM AND AT YOUR INDEPENDENT RISK.

FURTHER, CUSTOMER SEGREGATED FUNDS ARE INDEED NOT SEGREGATED DESPITE ANY OF THE MYRIAD OF RULES THAT STATE TO THE CONTRARY. PARTICIPANTS SEEKING TO RECOVER THEIR FUNDS HELD IN CUSTOMER SEGREGATED ACCOUNTS OF A U.S. FCM MAY BE SUBJECT TO SUBSTANTIAL FEES FOR BANKRUPTCY TRUSTEE’S, ATTORNEY COSTS AND OTHER CREDITORS SEEKING TO SUPERCEDE YOUR POSITION IN THE RETURN OF YOUR FUNDS DUE TO THE DISSOLUTION OF THE FCM AND THE RESULTING DISTRIBUTION OF REMAINING ASSETS, IF ANY. FCM’S ARE PERMITTED TO UTILIZE UNRESTRICTED LEVERAGE OF YOUR FUNDS TO MAKE SUBSTANTIAL PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS EVEN THOUGH YOU ARE NOT ENTITLED TO PARTICIPATE ON ANY GAINS THEY MAY HAVE BY CONVERTING YOUR FUNDS. THE FCM IS ALSO NOT REQUIRED TO INFORM YOU IN ANY MANNER THAT THEY ARE STEALING YOUR FUNDS, FOR WHAT PURPOSE THEY ARE CONVERTING THESE FUNDS AND HOW MUCH LEVERAGE THEY ARE EMPLOYING WITH THE USE OF YOUR FUNDS. HOWEVER, IT IS WITH SPECIFIC PERMISSION FROM ALL UNITED STATES REGULATORS (CFTC, SEC, NFA, FINRA) THAT FUTURES EXCHANGES (CME, ETC.) AND FCM’S ALIKE CAN EMPHASIZE THE SAFETY OF YOUR FUNDS HELD IN SEGREGATED ACCOUNTS SOLELY FOR THE PURPOSE TO INDUCE YOU TO PARTICIPATE IN ANY CRIMES THEY COLLECTIVELY MAY PERMIT REGARDING THE OUTRIGHT CONVERSION, OR THEFT, OF YOUR MONEY REGARDLESS OF ANY ILLUSION YOU MAY HAVE TO THE CONTRARY.

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL OF THE RISKS AND OTHER CRIMINAL FACTORS NECESSARY TO EVALUATE YOUR PARTICIPATION IN THE UNITED STATES REGULATED FCM’S. THEREFORE, BEFORE YOU DECIDE TO PARTICIPATE THROUGH A UNITED STATES FCM AS THE CUSTODIAN OF YOUR MONIES, YOU SHOULD CAREFULLY CONSIDER UTILIZING A CUSTODIAN WITHIN A COUNTRY THAT DOES NOT REGULARLY, AND ARBITRARILY, ABROGATE THE RULES OF LAW SUCH AS THE UNITED STATES.

If You Thought Police Brutality Was Bad … Wait Until You See What Congress Wants to Do Next Week

The police brutality against peaceful protesters in Berkeley, Davis, Oakland and elsewhere is bad enough.

But next week, Congress will vote on explicitly creating a police state.

The ACLU’s Washington legislative office explains:

The Senate is gearing up for a vote on Monday or Tuesday that goes to the very heart of who we are as Americans. The Senate will be voting on a bill that will direct American military resources not at an enemy shooting at our military in a war zone, but at American citizens and other civilians far from any battlefield — even people in the United States itself.

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The Senate is going to vote on whether Congress will give this president—and every future president — the power to order the military to pick up and imprison without charge or trial civilians anywhere in the world.

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The power is so broad that even U.S. citizens could be swept up by the military and the military could be used far from any battlefield, even within the United States itself. The worldwide indefinite detention without charge or trial provision is in S. 1867, the National Defense Authorization Act bill, which will be on the Senate floor on Monday.

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I know it sounds incredible. New powers to use the military worldwide, even within the United States? Hasn’t anyone told the Senate that Osama bin Laden is dead, that the president is pulling all of the combat troops out of Iraq and trying to figure out how to get combat troops out of Afghanistan too? And American citizens and people picked up on American or Canadian or British streets being sent to military prisons indefinitely without even being charged with a crime. Really? Does anyone think this is a good idea? And why now?

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In support of this harmful bill, Sen. Lindsey Graham (R-S.C.) explained that the bill will “basically say in law for the first time that the homeland is part of the battlefield” and people can be imprisoned without charge or trial “American citizen or not.” Another supporter, Sen. Kelly Ayotte (R-N.H.) also declared that the bill is needed because “America is part of the battlefield.”

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The senators pushing the indefinite detention proposal have made their goals very clear that they want an okay for a worldwide military battlefield, that even extends to your hometown.

Part of an Ongoing Trend

While this is shocking, it is not occurring in a vacuum. Indeed, it is part of a 30 year-long process of militarization inside our borders and a destruction of the American concepts of limited government and separation of powers.

As I pointed out in May:

The ACLU noted yesterday [that] Congress is proposing handing permanent, world-wide war-making powers to the president – including the ability to make war within the United States:

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As I noted in 2008:

An article in the Army Times reveals that the 3rd Infantry Division’s 1st Brigade Combat Team will be redeployed from Iraq to domestic operations within the United States.

The unit will soon be under the day-to-day control of US Army North, the Army service component of Northern Command. The Army Times reports this new mission marks the first time an active unit has been given a dedicated assignment to Northern Command. The paper says the Army unit may be called upon to help with “civil unrest” and “crowd control”.

The soldiers are learning to use so-called “nonlethal weapons” designed to subdue unruly or dangerous individuals and crowds.

This violates posse comitatus and the Constitution. But, hey, we’re in a “national emergency”, so who cares, right?

(We’re still in a declared state of national emergency).

I noted a couple of months later:

Everyone knows that deploying 20,000 troops on U.S. soil violates Posse Comitatus and the Constitution.

And everyone understands that staging troops within the U.S. to “help out with civil unrest and crowd control” increases the danger of overt martial law.

But no one is asking an obvious question: Does the government’s own excuse for deploying the troops make any sense?

Other Encroachments On Civil Rights Under Obama

As bad as Bush was, the truth is that, in many ways, freedom and constitutional rights are under attack even more than during the Bush years.

For example:

Obama has presided over the most draconian crackdown on leaks in our history — even more so than Nixon.

As Marjorie Cohen – professor at Thomas Jefferson School of Law and past president of the National Lawyers Guild – writes at the American Constitution Society for Law and Policy:

Army Pfc. Bradley Manning, who is facing court-martial for leaking military reports and diplomatic cables to WikiLeaks, is being held in solitary confinement in Quantico brig in Virginia. Each night, he is forced to strip naked and sleep in a gown made of coarse material. He has been made to stand naked in the morning as other inmates walked by and looked. As journalist Lance Tapley documents in his chapter on torture in the supermax prisons in The United States and Torture, solitary confinement can lead to hallucinations and suicide; it is considered to be torture. Manning’s forced nudity amounts to humiliating and degrading treatment, in violation of U.S. and international law.

Nevertheless, President Barack Obama defended Manning’s treatment, saying, “I’ve actually asked the Pentagon whether or not the procedures . . . are appropriate. They assured me they are.” Obama’s deference is reminiscent of President George W. Bush, who asked “the most senior legal officers in the U.S. government” to review the interrogation techniques. “They assured me they did not constitute torture,” Bush said.

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After State Department spokesman P.J. Crowley criticized Manning’s conditions of confinement, the White House forced him to resign. Crowley had said the restrictions were “ridiculous, counterproductive and stupid.” It appears that Washington is more intent on sending a message to would-be whistleblowers than on upholding the laws that prohibit torture and abuse.

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Torture is commonplace in countries strongly allied with the United States. Vice President Omar Suleiman, Egypt’s intelligence chief, was the lynchpin for Egyptian torture when the CIA sent prisoners to Egypt in its extraordinary rendition program. A former CIA agent observed, “If you want a serious interrogation, you send a prisoner to Jordan. If you want them to be tortured, you send them to Syria. If you want someone to disappear – never to see them again – you send them to Egypt.” In her chapter in The United States and Torture, New Yorker journalist Jane Mayer cites Egypt as the most common destination for suspects rendered by the United States.

Read the rest of this entry »

click for updated futures

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Futures are screaming higher overnight on yet another European bailout deal for Italy.

According to unverified reports from La Stampa, the IMF is preparing a 600 billion euro ($794 billion) loan for Italy. The paper has refused to state where it got the information. (IMF denied this to Reuters)

But that small detail is of no consequence to traders hungry for some green on the screen after November saw $4.7 trillion wiped out from global equity values. If we were to open here, markets would gap up nearly 2%, breaking a seven-day losing streak for US equities. Asian stocks have already broken their 4 day losing streak, with the MSCI Asia Pacific Index gaining 1.3%.

A few caveats:

The bailout rumors are just that — rumors. Note that the U.S. is a major funder of the IMF, and a bailout of Italy with US Taxpayer dollars wont go over well in an election year.

Also note that the reporting on sales during Thanksgiving was filled with all manner of garbage (Sales climbed “16 percent to a record, said the National Retail Federation”)  I suspect we will see flat to 2% sales gains at best, and not these ridiculous outliers.

Regardless, don’t forget to bring your rally caps to work tomorrow. . .

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UPDATE: November 28, 2011 5:12am

IMF is denying the report in statements (Reuters)

A story, a work of art, a face, a designed object — how do we tell that something is beautiful? And why does it matter so much to us? Designer Richard Seymour explores our response to beauty and the surprising power of objects that exhibit it.

Designer Richard Seymour works on products with soul — from a curvy, swoopy iron to a swift and sleek city motorcycle. Seymourpowell is regarded as one of the world’s leading product and innovation design consultancies, with clients who include Ford, Virgin Galactic, Tefal, Casio, Nokia, Guinness, Samsung and Unilever. Seymour is also consultant global creative director of design to Unilever’s Dove, Axe/Lynx and Vaseline brands.

The pair have appeared extensively on British television, most notably in two series on design for Channel 4: Better by Design and Designs on your…. They have also appeared on Design Challenge and several radio productions. In the 1980s, Seymour co-wrote the book The Mirrorstone, with Michael Palin, a children’s book full of holograms.

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Source:
Mapping Black Friday insanity on Twitter
Tom Cheredar
Venture Beat November 24, 2011
http://venturebeat.com/2011/11/24/black-friday-shoppers-twitter/