About our slowing GDP: are we near a recession? are the models accurate?

Summary: Some good news about the US economy, and a cautionary note about popular investment advice. It’s a bit technical, but explains important matters seldom mentioned. (1st of 2 posts today.)

Investment experts bombard America with forecasts, picking from the flood of data those tidbits that fit their views, often shown without context. It’s motivated reasoning, an easy path to plausible and entertaining but false reasoning. For example, the weak Q1 GDP has excited the bears, as has the Atlanta Fed’s GDPnow model’s forecast of only 0.7% SAAR GDP in Q2 (since it’s giving bearish forecasts, bears have deemed the GDPnow model the next Einstein). That’s far below the consensus guess of 2.5%, per the Fed’s May 15 survey of professional forecasters.

In his May 13 report Ethan Harris, economist for Bank of America, explains the situation, discussing the difficulty of forecasting GDP, the various models economists use, and the consensus confidence that US growth will accelerate from the near-zero Q1. Excerpt…

Hot hand

For the second year in a row, economists have come into the first quarter forecasting 3% GDP growth, then lowered their forecast to about 1% by the end of the quarter, only to see a roughly flat official release. By contrast, the GDPNow model from the Atlanta Fed “nailed” the latest quarter, predicting almost exactly the 0.2% advance estimate. Looking ahead, the model predicts just 0.8% for 2Q, compared to a 2.9% consensus. Should we be worried?

The short answer is: “not really.” The GDPNow model actually has a slightly worse forecasting record than both BofAML and the consensus over the last several years.

Casting for a better forecast

In recent years economists have developed increasingly sophisticated models for
estimating GDP in real time. … The Atlanta Fed takes a more high tech approach. Without boring the reader, their initial forecast each quarter is based on a “Bayesian Vector Autoregression (BVAR)” — basically an elaborate extrapolation of recent trends in the data. They then feed in hard data for the quarter as it is released and modify the forecast accordingly. While their model was spot on in the latest quarter, its real-time forecasting record is slightly worse than both our own and the consensus. …

Man verse models

What about the dismal 0.8% GDPNow number for 2Q? Keep in mind that this is based on their BVAR model before important hard data have been released. Like other forecasts it is an initial guess for the quarter. Looking back to last quarter, the initial GDPNow forecast was 2.2%, which turned out to be only modestly better than our forecast and the consensus. Moreover, as with their end of quarter forecasts, their initial forecasts have slightly higher forecast errors than both BofAML and the consensus. It is fair to say that GDPNow is a nice tool, but it does not warrant special attention.

Fooled by randomness?

Stepping back, the rather depressing reality is that it is hard to forecast quarterly GDP. Forecasts at the start of recent quarters have had absolute average errors of 0.8 to 0.9% (Table 2). For an economy trending along at about 2.4% that is a big error. Moreover, even after much of the data have been released, and the forecast allegedly becomes an adding up exercise, the average absolute error remains 0.6 to 0.7%.

This unpredictability is one reason we don’t react strongly to one bad quarterly GDP number. The challenge for 2Q is that, since it starts out on such a soft note, the data have to get better quickly just to hit the 2.3% we are currently tracking. Looking further ahead, given the continued healthy growth in the “cleaner” payroll data and with economic fundamentals still supportive of growth, we remain cautiously optimistic.

The Atlanta Fed agrees with Harris about the accuracy of their model:

“Overall, these accuracy metrics do not give compelling evidence that the model is more accurate than professional forecasters. The model does appear to fare well compared to other conventional statistical models.”

Another reason not to panic about the weak Q1

Last year GDP was weak in Q1 but quickly bounced back. So might this year. Brilliant research by CNBC in April uncovered a problem with the BEA’s seasonal adjustments. New research from the Philadelphia Fed confirms that, and suggests shows that this pattern extends back to 1985, resulting from a flaw in seasonal adjustment process of the Bureau of Economic Analysis uses for GDP (Gross Domestic Income is not affected).

From 1985 to 2014, real GDP growth averaged just 1.87% (annual rate) in the first quarter, far below the average growth of 3.31% in the second quarter, 2.86% in the third quarter, and 2.74% in the fourth quarter. The differences between first-quarter growth and growth in the remaining quarters are statistically significant. …

Update: On May 20 the BEA posted a note acknowledging the problem and that they’re working on fixes. “If necessary, improvements to the seasonal adjustment methods for these series will be introduced as part of the regular annual revision to the national income and product accounts, scheduled for release in July 2015.”

Conclusions

Perhaps the big conclusions is that the belief that “economists don’t know nothing” is wrong (it’s frequently seen in comments here, and common as dirt in both the posts and comments at popular websites such as Zero Hedge). So much of what we read about economics is wrong.

As for the economy, last week’s update described the broad range of data showing that the US economy has weakened. We’re vulnerable to economic shocks — which might be domestic (the Fed rapidly pushing up rates) or from abroad (a large slowdown in China) — but are unlikely to fall into a recession without one.

The bears predict imminent doom, as they have for decades. Most mainstream economists predict a return to normal growth. Both are wrong so far. The latter is a hot topic among economists. Is something broken? Do we have secular stagnation? Have we begun a new economic regime? We should worrying about these things, rather than what GDP does during the next few months.