Define Economic Forecasting and Techniques

Economic Forecasting

Economy analysis is the first stage of fundamental analysis and starts with an analysis of historical performance of the economy. But as investment is a future-oriented activity, the investor is more interested in the expected future performance of the overall economy and its various segments. For this, forecasting the future direction of the economy becomes necessary. Economic forecasting thus becomes a key activity in economy analysis.

The central theme in economic forecasting is to forecast the national income with its various components. Gross national product or GNP is a measure of the national income. It is the total value of the final output of goods and services produced in the economy. It is a measure of the total economic activities over a specified period of time and is an indicator of the level and rate of growth of economic activities. An investor would be particularly interested in forecasting the various components of the national income, especially those components that have a bearing on the particular industries and companies that he is analysing.

Forecasting Techniques

Economic forecasting may be carried out for short-term periods (up to three years), intermediate term periods (three to five years) and long-term periods (more than five years). An investor is more concerned about short-term economic forecasts for periods ranging from a quarter to three years. Some of the techniques of short-term economic forecasting are discussed below:

Anticipatory Surveys

Much of the activities in government, business, trade and industry are planned in advance and stated in the form of budgets. Consumers also plan for their major spending in advance. To the extent that institutions and people plan and budget for expenditures in advance, surveys of their intentions can provide valuable input to short-term economic forecasting.

Anticipatory surveys are the surveys of intentions of people in government, business, trade and industry regarding their construction activities, plant and machinery expenditures, level of inventory, etc. Such surveys may also include the future plans of consumers with regard to their spending on durables and non-durables. Based on the results of these surveys, the analyst can form his own forecast of the future state of the economy.

The greatest shortcoming of the anticipatory surveys is that there is no guarantee that the intentions surveyed will certainly materialise. The forecast based on anticipatory surveys or surveys of intentions will be valid only to the extent that the intentions are translated into action. Hence, the analyst cannot rely solely on these surveys.

Barometric or Indicator Approach

In this approach to economic forecasting, various types of indicators are studied to find out how the economy is likely to perform in the future. These indicators are time series data of certain economic variables. The indicators are classified into leading, coincidental and lagging indicators.

The leading indicators are those time series data that reach their high points (peaks) or their low points (troughs) in advance of the high points and low points of total economic activity. The coincidental indicators reach their peaks and troughs at approximately the same time as the economy, while the lagging indicators reach their turning points after the economy has already reached its own turning points. In this method, the indicators1 act as barometers to indicate the future level of economic activity. However, careful examination of historical data of economic series is necessary to ascertain which economic variables have led, lagged behind or moved together with the economy.

The US Department of Commerce, through its Bureau of Economic Analysis, has prepared a short list of the different indicators. Some of them are given below for illustrative purpose.

Leading Indicators

Average weekly hours of manufacturing production workers

Average weekly initial unemployment claims

Contracts and orders for plant and machinery

Number of new building permits issued

Index of S and P 500 stock prices

Money supply (M2)

Change in sensitive materials prices

Change in manufactures’ unfilled orders (durable goods industries)

Index of consumer expectations

Coincidental Indicators

Employees on non-agricultural pay rolls

Personal income less transfer payments

Index of industrial production

Manufacturing and trade sales

Lagging Indicators

Average duration of unemployment

Ratio of manufacturing and trade inventories to sales

Average prime rate

Commercial and industrial loans outstanding

Change in consumer price index for services

Of the three types of indicators, leading indicators are more useful for economic forecasting because they measure something that foreshadows a change in economic activity.

The indicator approach has its own limitations. It is useful in forecasting the direction of the change in aggregate economic activity, but it does not indicate the magnitude or duration of the change. Further, the leading indicators may give false signals. Moreover, different leading indicators may give conflicting signals. The indicator approach becomes useful for economic forecasting only if data collection and presentation are done quickly. Any delay in presentation of data defeats the purpose of the indicators.

Econometric Model Building

This is the most precise and scientific of the different forecasting techniques. This technique makes use of Econometrics, which is a discipline that applies mathematical and statistical techniques to economic theory.

In the economic field we find complex interrelationships between the different economic variables. The precise relationships between the dependent and independent variables are specified in a formal mathematical manner in the form of equations. The system of equations is then solved to yield a forecast that is quite precise.

In applying this technique, the analyst is forced to define learly and precisely the interrelationships between the economic variables. The accuracy of the forecast derived from this technique would depend on the validity of the assumptions made by the analyst regarding economic interrelationships and the quality of his input data.

Econometric models used for economic forecasting are generally complex. Vast amounts of data are required to be collected and processed for the solution of the model. This may cause delay in making the results available. Undue delay may render the results obsolete for purpose of forecasting.

Opportunistic Model Building

This is one of the most widely used forecasting techniques. It is also known as GNP model building or sectoral analysis.

Initially, an analyst estimates the total demand in the economy, and based on this he estimates the total income or GNP for the forecast period. This initial estimate takes into consideration the prevailing economic environment such as the existing tax rates, interest rates, rate of inflation and other economic and fiscal policies of the government.

After this initial forecast is arrived at, the analyst now begins building up a forecast of the GNP figure by estimating the levels of various components of GNP. For this, he collects the figures of consumption expenditure, gross private domestic investment, government purchase of goods and services and net exports. He adds these figures together to arrive at the GNP forecast.

The two GNP forecasts arrived at by two different methods will be compared and necessary adjustments will be made to bring the two forecasts into line with each other.

The opportunistic model building approach makes use of other forecasting techniques to build up the various components. A vast amount of judgement and ingenuity is also applied to make the overall forecast reliable.

Economic forecasting is an extremely complex and difficult process. No method is expected to give accurate results. The investor must evaluate all economic forecasts critically before making his investment decision.

Economy analysis is an important part of fundamental analysis. It gives the investor an overall picture of the expected performance of the economy in the near future. This is a valuable input to investment decision-making.