NY Fed’s introspection in failure to forecast the Great Recession

Superb post by Simon Potter of NY Fed.

He points to NY Fed forecasts in 2007 and how they missed the bus. They were right on inflation but missed the numbers big time on growth and unemployment:

Economic forecasters never expect to predict precisely. One way of measuring the accuracy of their forecasts is against previous forecast errors. When judged by forecast error performance metrics from the macroeconomic quiescent period that many economists have labeled the Great Moderation, the New York Fed research staff forecasts, as well as most private sector forecasts for real activity before the Great Recession, look unusually far off the mark.

One source for such metrics is a paper by Reifschneider and Tulip (2007). They analyzed the forecast error performance of a range of public and private forecasters over 1986 to 2006 (that is, roughly the period that most economists associate with the Great Moderation in the United States).

On the basis of their analysis, one could have expected that an October 2007 forecast of real GDP growth for 2008 would be within 1.3 percentage points of the actual outcome 70 percent of the time. The New York Fed staff forecast at that time was for growth of 2.6 percent in 2008. Based on the forecast of 2.6 percent and the size of forecast errors over the Great Moderation period, one would have expected that 70 percent of the time, actual growth would be within the 1.3 to 3.9 percent range. The current estimate of actual growth in 2008 is -3.3 percent, indicating that our forecast was off by 5.9 percentage points.

Using a similar approach to Reifschneider and Tulip but including forecast errors for 2007, one would have expected that 70 percent of the time the unemployment rate in the fourth quarter of 2009 should have been within 0.7 percentage point of a forecast made in April 2008. The actual forecast error was 4.4 percentage points, equivalent to an unexpected increase of over 6 million in the number of unemployed workers. Under the erroneous assumption that the 70 percent projection error band was based on a normal distribution, this would have been a 6 standard deviation error, a very unlikely occurrence indeed.

The economic performance has improved since then but again the forecasts were rosier for 2011:

In contrast, the New York Fed staff forecasts for 2010 made in 2009 and early 2010 are quite accurate (under the assumption of no major revisions to the estimates of GDP growth in 2010). This accuracy, however, has not been sustained through 2011. As widely discussed by a number of Federal Reserve officials, the level of real activity in 2011 has been disappointing relative to expectations. This shortfall is evident in the chart below, which compares forecasts for GDP growth in 2011 and 2012 produced in April and October 2011. However, this chart also depicts the uncertainty and risks around the staff forecast as of April 2011. Given the uncertainty around the April forecast, the subsequent changes to the outlook are not very surprising. On the other hand, near-term downside risks to this forecast were low compared to other forecasts produced in the last four years, so the direction of the change was more surprising.

So what led to mistakes in forecasting the recession? Well it was complacency:

Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out:

  1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
  2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff report by Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
  3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008. Eventually, by building on the insights of Adrian and Shin (2008), we gained a better grasp of the power of these feedback loops.

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation.

Superb stuff..Some honesty there. Need to so more of this from others in the business as well..

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