Economic Forecasting in a Business Environment
Klein, Lawrence, The Journal of Business Forecasting Methods & Systems
Leaders of important enterprises are often heard to have remarked, "If I had only known--, I would have chosen a different strategy." The blank may have been end of the Cold War, downsizing of the defense establishment, the run-up of interest rates, the bursting of the real estate price bubble, or similar events. Some of these events are purely economic; some have significant political components; others may have large sociological or legal components. They all affect the functioning of enterprise, and it is up to the business strategist to try to look ahead to make sure that an appropriate work force is at hand, that inventory stocks (raw materials or finished goods) are adequate, that key items of fixed capital are on order or already installed.
THE FORECASTER'S JOB
The economic forecaster's job is to try to look ahead, unconditionally; to assess the implications of "what-if" conditional options; to present appropriate error bands of judgment; and to recommend some appropriate lines of action. I plan to tell you something about my latest investigations to make very short-run economic forecasts--up to six months, with frequent replication, weekly or even daily--but also to comment on both medium term forecasts--up to 3 to 5 years--and longer term forecasts--up to 10 years. Some economists have an eye on longer horizons for several decades into the future--but those are highly conditional scenarios and not, strictly speaking, forecasts in the usual sense of the term.
Forecasting for business may overlap considerably with forecasting for public bodies but the targets in the bottom-line may be quite different and the scope may be quite broad. The national public sector is particularly interested in macroeconomic forecasts of total production (GDP), inflation (change in the CPI), the unemployment rate, the number of jobs created, the internal balance (surplus or deficit) and the external balance (current account), representative interest rates and currency exchange rates. International public organizations have the same bottom-line interests but they also follow distributions among countries or regions. Local government units have a much more restricted scope, but usually are interested in local area analogues of the same magnitudes that national governments follow.
The primary targets for private business are company sales, profits, debt ratios, debt service burdens, market valuations of equities, company inventory positions, and the impact of state, local, or national legislation. The biggest private companies, whose sales may be as large as one-half percent or more of GDP, may have direct interest in the national macroeconomic magnitudes, but for the most part their interest is indirect; that is to say, they are mainly interested in macroeconomic magnitudes because they shape the environment for company performance.
At the present time, however, the most frequent inquiry that is posed to economic forecasters is "Where are interest rates headed?" In my service as a board member and chairman of the economic policy committee of an investment banking company, I find myself being quizzed mainly about the course of interest rates. But this firm's revenues are partially indexed to inflation; so there is corresponding curiosity about the course of inflation. Overall macroeconomic performance is less interesting for this company, except as it has indirect effects on the company's bottom line.
During the years when I was responsible for much of the work at Wharton Econometrics, I had to serve hundreds of users, some in specific microeconomic investigations but mostly in overall macroeconomic studies, I found that it was necessary to be prepared to relate overall economic performance to the fortunes of many diverse users of forecasts.
Economic forecasters, whether by judgment or by formal system, are well aware of the inevitable presence of error. Also, those who engage in this activity with a strong scholarly background are well aware of the orders of magnitude of error and their root causes; nevertheless we serve as the butt of jokes by many outsiders who do not realize just how difficult it is to forecast the economy accurately. …