Economic forecasting is the process used in trying to predict or anticipate future economic conditions by using various economic variables and indicators.
Economic forecasting is based on the statistical methods of forecasting, which use variables, their relation to each other, and their relationship to the overall economy.
Understanding Economic Forecasting
Economic forecasting makes use of historical data points that have been released in previous economic reports for countries or geographical regions. Generally, economic forecasting is centered around predicting the growth in Gross Domestic Product (GDP) for an economy.
GDP measures the total value of goods and services produced in an economy over a period. It is widely considered to be a proxy for the wealth of an economy since an economy that produces more is considered more affluent.
GDP growth is an important number that is used by economists, businesses, government entities, and investors. Decision-making across these stakeholders is impacted by the forecasted GDP growth that is released by governments.
Businesses use economic forecasts to plan their operating activities. If the growth in GDP is expected to be strong, they can expect to have more disposable income, and they may decide to ramp up their capital expenditures.
Government entities use forecasts to plan their policy-making efforts as well. Fiscal policies and monetary policies are implemented based on the expectation of GDP growth.
If the growth in GDP is expected to be strong, the government may enact tighter policies. On the other hand, if GDP growth is expected to be slow, the government may enact expansionary policies.
Investors also use GDP growth forecasts to make informed decisions. If the economy is expected to be strong, they may be more comfortable investing in riskier assets, whereas if the economic conditions are expected to weaken, investors may be more conservative with their asset allocation.
An economy will release what is known as indicators, which are specified data points relating to the economy. The indicators relate to the economic cycle, which is the state of the economy that is being experienced. There are two types of indicators:
1. Lagging Indicators
A lagging indicator is an observable economic variable that changes significantly after a change has been observed in the real economy.
Lagging indicators are used to inform which stage of the business cycle an economy is in. They are also used to identify the overall trend of the economy and are used by individuals, businesses, and government entities to make informed decisions.
The common characteristic among the lagging indicators is that the shift in them occurs only after there has been a shock to the economy.
For example, during the 2008-2009 Global Financial Crisis, corporate earnings of companies were not observed to have fallen until after the housing market bubble had already popped.
2. Leading Indicators
A leading indicator is an observable economic variable that changes significantly before a change has been observed in the real economy.
Leading indicators are used to predict when changes in the economic cycle may occur and predict other significant shifts in the economy. As you can imagine, leading indicators are critically important in economic forecasting since they are the main inputs in the statistical models used to forecast economic conditions.
It should be noted that the data points are gathered from the past, and the past does not necessarily inform future conditions. Therefore, leading indicators are not always accurate, but they provide some insights and are widely used by individuals, businesses, and government entities.
Examples of leading indicators are:
Corporate Capital Expenditures
Purchasing Managers Index (PMI)
Consumer Confidence Index
The common characteristic among the indicators above is that the shift in them occurs before there is a shock to the economy.
A more general example is if aggregate corporate capital expenditures are falling, future earnings growth can be expected to be lower and negatively impact the real economy in the future.
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