conference is entitled “Forecasting”.
Naturally, each forecast carries with it the likelihood, sometimes high,
that it will not come to pass. In
economics, some of the uncertainty regarding the future comes from the fact
that when preparing the forecast, we don’t always exactly know the current
state of the economy or, as I will soon show, even the state of the economy in
the past. I will describe how we, like other central banks, manage monetary
policy given the uncertainty in terms of the environment it is supposed to
influence, particularly in view of the fact that monetary policy affects the
economy with some lag.
I illustrate the limitations each forecaster in the economic environment faces,
allow me to quote prof. Philip Tetlock, who has for years been researching the
ability to forecast political and economic events. A book he wrote in 2006, which is based on
statistics from 20 years of forecasting, became famous for its conclusion that
“the average expert is about as good at predicting what the future holds as a
dart-throwing chimp is at hitting the bullseye.” His new book was published in 2015, and is
also based on tracking the forecasting abilities of a great number of
people. In that book, he comes to a more
optimistic conclusion: There are people who are better than others at
forecasting, and the work of forecasting can be improved based on experience
economic policy is based on the ability to forecast the economic environment of
the future. What can we say about
forecasting ability in this area?
Israel, given that we are a small and open economy, the main input in
forecasting the performance of the Israeli economy is the forecast of the
global environment, particularly world trade.
At the Bank of Israel, we do not pretend to forecast the main
developments for the global economy on our own.
Rather, we rely on forecasts from the main international
organizations. For instance, the
International Monetary Fund is the most professional body in preparing
forecasts of the global economy, and even the forecasts it publishes are
subject to frequent revisions of significant scope. At the beginning of 2016, the IMF forecast
that world growth would increase by 4 percent.
In October, the revised forecast estimated trade at just 2.3
percent. It is important to emphasize
that world trade is the most important global economic variable from the
standpoint of the Israeli economy.
economy is characterized by what economists call a serial correlation. For instance, the determination of annual GDP
is not disconnected from that of the previous year. Inflation in the coming quarter is influenced
by inflation in the current quarter, and so forth. Therefore, when preparing a forecast, it is
necessary to assess the current activity environment (or that of the recent
past). But when dealing with
macroeconomic figures, it turns out that the past is still before us. Revisions are made every month in Israel’s
quarterly GDP growth figures.
example of a particularly sharp revision was in the figures for the first
quarter of 2016. In the first
publication of those figures, GDP growth was estimated at 0.8 percent—a very
low figure that was interpreted as a marked slowdown in economic activity. However, the figure was revised upward each
month, and in November, the estimate for first quarter GDP growth was already
3.2 percent—meaning strong growth, and in line with the rapid growth that we
saw in the labor market, which was a kind of mystery to us given the low growth
figures. Essentially, the labor market
figures, including figures from the Labor Force Survey, are more stable
indicators than National Accounts figures, and provided an earlier indication
(as it later turned out) of the positive state of the economy.
source for the exceptional upward revision in the first half of 2016 was mainly
revisions in export and investment figures (especially investment in
construction). It turns out that
revisions in the National Accounts figures are common and substantial, but that
there is no systematic deviation in either positive or negative direction
(which obviously does not enable an informed assessment of the direction of the
revision in advance). Parenthetically, the revisions in the GDP components, particularly
the change in exports, are much higher.
the revisions in the National Accounts data excessively large? It turns out they are not. There are significant revisions in other OECD
countries as well, some of which are even larger, and the scope of our
revisions is above the median in OECD countries, but below the average, which
is affected by a number of countries with particularly large revisions. While we are in good company, the troubles of
many in this case are not a source of even partial comfort, and do not make it
easier for policy makers to manage policy in such an uncertain environment.
is perhaps the place to mention the famous statement by my colleague Janet
Yelin, Chairman of the Federal Reserve, who tried to convince the markets that
the policy adopted by the Fed is data dependent, meaning that it is not set in
advance, but is based on currently published data. I hope that I have succeeded in illustrating
how challenging it is to determine policy based on data in view of the fact
that the data are subject to significant revisions.
even the past is still before us, is there a reason to try forecasting the
Forecasting is a necessary
tool for policy makers in any field, and policy makers need to
examine the scenario in accordance with an assessment of the cost or damage
involved in adopting a given policy path.
We must assess the likelihood of the realization of various scenarios,
what the result of adopting a given policy will be along various paths, and
particularly, the risks against which the policy must protect.
Planners in the education
system need to assess how many children will live in a given locality, the
margin of error of the forecast, and the damage that would occur if not enough classrooms
are built against the cost of building too many classrooms.
The defense establishment
must assess the reference scenario for the threats we face, the damage
resulting from an under-assessment, and the cost of an over-assessment.
The financial supervisory
authorities must assess the extent of damage from a financial crisis compared
to the economic cost of security buffers that are too deep.
Monetary policy makers must
use the best tools available to them to assess the forces acting on the economy
and what direction their effect is expected to take, and formulate a picture of
the future situation based on data, models, experience and know-how in order to
set the policy path.
management must take into account the margin of uncertainty, and decide the
correct weight to attribute to various possible scenarios.
order to make monetary policy effective, a balance is required between the need
to be ahead of the curve in view of the lags in the effect of monetary policy,
and the need to respond immediately to real developments rather than the
“noise” in the data.
after all the warnings about forecasting, the time has come to present the
forecast. The Bank of Israel Research
Department formulates a forecast of the economic environment every quarter,
based on models, information, and forecasts of the global economy, and the data
(the best that can be obtained) describing the recent developments in the
domestic economy. After all of these are
put together into the “oven”, the raw forecast emerges. But this is not the forecast that is
presented to policy makers or the public.
The economists examine the result, and exercise judgement regarding the
likelihood of various variables, factors that the models do not cover, and
more. The final result is the forecast
that was published two days ago and is presented before you. This forecast serves as an
ingredient—important though not exclusive—in the formulation of the situational
assessment that forms the basis for the Monetary Committee’s decisions.
forecast indicates expected growth of 3.5 percent this year (as we said, the
past is still before us), 3.2 percent in 2017 and 3.1 percent in 2018. It indicates a gradual slowdown in private
consumption after an exceptional increase this year, growth in public
consumption of more than 4 percent this year and 1.5 percent in the next two
years, in line with the two-year budget, and a gradual acceleration of exports
supported by a gradual recovery that the international organizations project in
with the central scenario in the forecast, the Research Department also
presents the uncertainty that exists in the forecast. This is illustrated by a fan chart, which
shows 66 percent of the distribution of possible outcomes. The uncertainty in the forecast is derived
from uncertainty in the exogenous variables inserted into the model, chiefly in
relation to the global environment. By
the end of 2017, the breadth of outcomes ranges from growth of slightly more
than 2 percent to about 4.5 percent.
important component in assessing the picture based on which policy is
formulated is the development of the relevant exchange rate (the effective
exchange rate), which has been in a trend of appreciation for the past two
years. This was affected not only by
basic economic forces, but also by the very accommodative policies of our main
trading partners (which, according to the updated assessment of the federal
funds rate, is expected to become less accommodative in the coming year).
to the forecast, inflation is expected to return to within the target range in
2017, but the range of uncertainty surrounding the timing of that return to the
range is broad.
addition to the forecast regarding the macroeconomic picture, the forecast
presented by the Research Department to the Committee also includes the path of
the interest rate that is consistent with the macroeconomic picture emerging
from the forecast and that supports its realization. Herein lies the importance of using an
economic model that ensures the consistency of each component of the picture
and of policy.
forward, based on the updated situational assessment, the Research Department’s
assessment is that the interest rate is expected to begin increasing in the
last quarter of 2017. Here too, the
range of possible interest rate paths is very broad, and relates to a broad
range of forecasts of economic activity.
It is important to emphasize that this is the interest rate path
assessed by the Research Department as consistent with the other components of
the macroeconomic forecast, and that also serves as input for the Monetary
Committee’s discussions. It is not
necessarily the path that the Monetary Committee members view as the future
interest rate path, and it certainly is not binding on the Monetary
part of the forecast, we also indicate the main risks to the forecast that has
been formulated, and discussion of these risks serves as input in the
formulation of policy.
Research Department’s assessment is that the risks to the current forecast are:
Uncertainty surrounding the
markets’ response, including that of the foreign exchange market, to the
increase in the federal funds rate and extension of quantitative easing in
Europe—the creation of a split in the direction of change in monetary policy
between the two blocs.
Uncertainty regarding the
trend of world trade and of global growth against the background of increasing
calls to raise international trade barriers.
on the macroeconomic picture sketched out through the forecast, the additional
information I mentioned, and the assessment of the various risks to its
realization, as formulated during the year, the accommodative policy outlined
by the Bank of Israel’s Monetary Committee has been reflected in maintaining
the interest rate at the low level of 0.1 percent, and for the first time, in
October 2015, the Committee published an assessment that this policy would
remain in place for a considerable time.
Such an announcement is referred to in central bank parlance as “forward
guidance”, and has the power to affect long-term interest rates as well, beyond
the effect on the short-term interest rate set by the central bank. This is in addition to intervention in the
foreign exchange market, which included a component offsetting the negative
effects of pressure on the exchange rate derived from natural gas production,
and intervention in order to prevent too sharp a deviation from the exchange
rate derived from the basic economic forces.
Monetary Committee’s policy also took into account the main risks to the
economy as presented in the situational picture that was formulated, including
in view of the continued decline in exports, the continued deviation of
inflation from the target range, and the financial risks derived from the
mortgage market. This policy has served,
and continues to serve, in achieving policy targets, chiefly the return of
inflation to within the target range, and support of economic activity and of
macroeconomic picture that arises from the updated forecast, as well as the
state of the labor market as shown by employment and wage figures, are
positive, certainly when taking into account that the state of the global
economy is far from one of high growth.
The relatively good macroeconomic situation provides a fitting time to
focus on solving fundamental problems in the Israeli economy that may have an
effect on its ability to achieve inclusive and sustainable growth. Chief among those are increasing
productivity, improving human capital, reducing bureaucracy, and dealing with
the long-term implications of expected demographic developments.