CEOs Less Confident About Economic Forecasts

| About: ProShares Inflation (RINF)

"CEOs Put Less Stock in Predictions" reports The Wall Street Journal. As a long-time forecaster, I support that move. Not "zero stock in predictions" but "less stock."

Here's a guide to where you should rely less on expert predictions, and where you should rely more heavily.

Prices that come out of auction markets are the hardest to predict. That includes foreign exchange rates and interest rates. Suppose that some new information arises that leads all the experts to believe that the dollar should be ten percent higher in 12 months. Traders would immediately start buying dollars, pushing the price up immediately. The change won't take 12 months to occur, it will take just minutes. Thus, all the information used to predict future exchange rates is already embodied in today's exchange rate. A forecast of further change is bound to fail. This challenge applies equally to interest rate predictions.

Commodity prices share similarities to the auction markets of foreign exchange and interest rates, but with more of a connection to physical reality. Imbalances between current production and current consumption eventually get resolved, presenting some opportunities for successful forecasting. In July 2014, when oil was trading over $100 a barrel, a number of us cautioned that production was increasing rapidly while consumption was barely growing. Those who looked only at the price line saw no reason for a sudden collapse. The moral of the story is that insight into fundamentals can help even in auction markets.

Inflation is easier to forecast. If all economists come to expect higher inflation, there is no market mechanism to change prices instantly. Our forecast can come true. There is also a great deal of momentum in inflation, making forecasting easier.

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The "real side" of the economy - spending, production and employment - is also much easier to forecast than auction market prices. However, be aware that economists have not done a great job at finding turning points. When the economy is booming, we are not good at knowing whether we are headed for another boom year or a recession. (The forecasting track record is described in Chapter 2 of The Flexible Stance.)

That sounds pretty pessimistic, and it's a reason that I emphasize that companies should be ready for surprises in the economy. One thing that economics can do for management, though, is to help understand what could drive the internal forecast.

Let's say that someone in marketing predicts an eight percent gain in the top line next year. As an economist, I think of three possible rationales for an aggressive sales forecast:

  1. Strong economic activity overall
  2. Strong industry sales relative to the economy, and/or
  3. Gains in market share.

I would press the forecaster for an explanation as to which of these factors drives the sales forecast.

Finally, some CEOs are frustrated by inaccurate political forecasts. For the most part, though, they are paying too much attention to politics. As I wrote in "How Bad Will The New President Be For The Economy?" the most worrisome policy proposals of the candidates have the least potential for passage through Congress. CEOs may need to think a lot about regulatory policy in their particular industries, but they should not spend much time on big-picture politics.

The CEOs surveyed in the article are right to be skeptical of forecasts. Flexibility and agility of execution are more important. But every business opens its doors in the morning with an implicit forecast: that some customer will want to do business. Forecasting is unavoidable, but betting one's company on a forecast isn't.