This 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.
Before 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
Managing economic policy is based on the
ability to forecast the economic environment of the future. What can we say about forecasting ability in
In 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.
The 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.
One 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.
The 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.
Are 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
This 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.
If even the past is still before us, is
there a reason to try forecasting the future?
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.
o 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.
o 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.
o 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.
o 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 management must take into account the
margin of uncertainty, and decide the correct weight to attribute to various
In 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.
So 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.
The 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 world trade.
Together 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.
Another 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).
According 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.
In 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.
Looking 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 Committee.
As 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.
The 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.
Based 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
The 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 employment.
The 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.