The reason for forecasting is clear. Governments, organisations, companies and individuals all want to know what the future holds for them. A view of the future allows each of them, in their own way, to plan for it.

• For companies, it gives them a view of future spending patterns and some idea of future demand for their product. In turn this enables them to adjust their capital investment programmes to provide sufficient production capacity.
• For individuals, it provides information on how best to balance current spending, saving and borrowing.
• Governments are better able to forecast tax revenues and expenditure on areas such as unemployment benefits if they can predict how the macro economy will behave.

For the Bank of England, charged with keeping inflation under control, a view of the future is essential. The Monetary Policy Committee uses a very short term interest rate in its pursuit of its inflation target but changes in interest rates affect inflation with a substantial lag of up to two years.

• The MPC needs to have a good grasp of current economic conditions and the direction in which the economy is currently moving.
• It also has to have a view on where inflation and growth are going to be in two to three years.

Should those forecasts not be consistent with the Bank’s inflation target, action would need to be taken now.

For various reasons, forecasts don’t always turn out to be right, of course.

Forecasting methods are not infallible. Models are not as accurate as some economists would like us to believe, as the current recession has proved. Poor methodology and poor data used in estimating the equations will provide poor output. Rubbish in means rubbish out.

Moreover, economic models, by their nature, do not forecast one off economic shocks. David Hendry, Professor of Economics and Chairman of Economics Department, University of Oxford and a leading econometrician, notes that unanticipated large changes are the main reason for forecasting errors. Such shocks should lead to a rapid reappraisal of forecasts.

Forecasting is not a mechanical process based solely on reading off the results of models.

Mervyn King, the Governor of the Bank of England, in the foreword to The Bank of England Quarterly Model, notes that “all economic models, however good, represent simplifications of reality and, as such, no single model can possibly address the many and varied issues that matter for economic policy. This recognition is central to the Bank’s use of economic models and its approach to economic forecasting. The Bank relies on a plurality of models to help inform the Committee’s projections. And these models are used as tools to help the Committee reach the economic judgements that play a critical role in shaping its projections, rather than simply to generate mechanical forecasts. Economic forecasting is ultimately a matter of judgement.”

To highlight how the judgement used in economic forecasting can vary enormously from economist to economist, one need merely to look at a publication produced monthly by HM Treasury. “Forecasts for the UK Economy” is a compendium of forecasts produced by various economic forecasting teams in the UK and includes the collected views of 25 City forecasters, mainly banks, and 15 other organisations including universities, economic consultancies, the IMF and the OECD. HSBC’s forecasts are included in the former group while Oxford Economics, who provided the small macro econometric model in this website, are in the latter.

Comparison of these forecasts may be a little unfair because of timing differences – forecasts appearing in the June 2009 publication were made mostly that month but some had not been updated for several months. Yet even those made in the same month showed a remarkable variation, given that they were largely put together using the same information.

Just looking at two variables, for instance, highlights the range of forecasts.

• The most optimistic forecast for GDP growth for 2009 was -2.5%, the most pessimistic was
  -4.5% and the median forecast was for a fall of 3.8%.
• For inflation, the highest forecast was for 1.8% by the end of 2009, the lowest was for -0.1% and the median was 1.0%.

And these were made when the economy was already nearly a half way through the year!

For 2010, the forecasts were even wider.

• The most optimistic forecast for GDP growth was growth of 2% but the lowest estimated that output would fall by 1.3%! The median view was that growth would be 0.5% in 2010.
• For inflation, forecasts ranged from a low of 0.5% to a high of 3.7% with the median at 1.4%.

Click here for the HM Treasury table of forecasts which is taken from the June 2009 edition and shows forecasts of the expenditure components of GDP for 2010.