Introduction and summary
Increases in real U.S. gross domestic product (GDP) averaged an annual rate of 3.2 percent between the fourth quarters of 1991 and 1995 (the solid line in panel A of figure 1), a relatively slow pace of growth considering that the economy was emerging from the 1990-91 recession. Output then surged in the second half of the decade, with current estimates showing real GDP rising at an average annual rate of 4.4 percent over the 1996-99 period. At the same time, inflation fell, with the rate of increase in consumer prices (measured by the Consumer Price Index, or CPI) moving from 5.4 percent in 1990 to an average of just 2.4 percent in the second half of the decade (solid line in panel B). The bars in the graphs show average forecasts of real GDP growth and CPI inflation made at the beginning of each year. (1) Between 1996 and 1999, average real GDP forecasts were in the range of 2.1 percent to 2.3 percent, while the CPI forecasts were in the range of 2.2 percent to 3 percent. Clearly, forecasters failed to pred ict the outstanding performance of the economy--they consistently underpredicted GDP growth and, though to a lesser degree, they overpredicted inflation.
At the turn of the millennium, forecasts for real GD? Growth were in the range of about 3 percent to 3.5 percent. While not quite as robust as the actual rates of growth recorded during the second half of the decade, this still represented a solid gain in output and a step up from the projections made in that earlier period. Instead, in the second half of 2000, the expansion began to falter. The weakness intensified in early 2001, with the economy falling into recession in March. So again, forecasters failed to predict a major development in the economy.
How should we interpret these forecast errors? The economy is always being hit by shocks, and real GDP growth naturally fluctuates a great deal. Furthermore, recessions are irregular occurrences that can be generated by a variety of unforeseeable events. So, were the forecast errors during the 1996-2001 period unusual, or did they simply reflect the inherent difficulties in forecasting? If the errors were unusual, then why is this so? In particular, did forecasters change the way that they were constructing projections, or did the economy behave in an unusual manner? This article addresses these questions.
To do so, I first present a narrative account of the evolution of real GDP forecasts made during the 1996-2001 period. This narrative shows, qualitatively, that forecasters appeared to view most of the errors they were experiencing during the 1996-99 period as transitory and left GDP projections at a pace just somewhat below their benchmarks for longer-run growth. However, around the turn of the millennium, they boosted their projections for GDP growth, both for the long run and the nearer term. Indeed, they did so just around the time that the economy began to weaken.
This strategy clearly resulted in some large and, during 1996-99, persistent forecast errors for real GDP. I next show that, statistically, the 1996-99 errors were unusual-based on forecasters' track records, the odds of seeing such a string of under-predictions were quite small. The forecast errors in 2000 and 2001, though large in an absolute sense, were not so significant relative to the performance around earlier turning points in the economy.
Next, I examine whether the errors were influenced by some change in the way forecasters were making their projections. I use semiannual data back to the early 1980s to characterize the "typical" way that forecasters adjust projections for growth at various forecast horizons. I find that forecasters appear to view most shocks as being transitory--they may alter their near-term outlook in response to incoming data, but they generally do not change medium- and longer-term forecasts very much. This means that perceptions of longer-run trends--or potential GDP growth--provide an important anchor for projections more than a couple quarters Out. …