Critics of Treasury’s budget forecasts reveal their own ignorance

Secretary of Treasury John Fraser, pictured with Finance Minister Mathias Cormann, has warned it is getting harder to forecast budget deficits and surpluses. Photo: Alex EllinghausenWe are entering peak killing season for Treasury forecasts.

With the federal budget just three weeks away, Treasury officials are working overtime to put the finishing touches on their forecasts for the economy, revenue and expenditure.

Treasury has come under intense scrutiny in recent years over the accuracy of its forecasts.

It has become the fallback position of every political hack in the budget lock up to throw doubt on Treasury’s forecasts: “A surplus in 2020, yeah, I’ll believe that when I see it!”

It is true that Treasury gets it wrong. All forecasters do.

But it’s a cheap shot to entirely write off the diligent work that Treasury officials do to put these forecasts together. Forecasting’s a dirty job, but someone’s got to do it.

And on the most recent evidence, a review in 2012, Treasury gets it wrong no more frequently or wildly than other private sector forecasters.

In a sense, economic forecasts are like poll results. Both exist within a margin of error. The analysts who produce them are quite open about that. But that often gets lost in translation when the media go on the hunt for a good yarn.

Political pundits faithfully report poll changes that lie comfortably within the survey’s margin of error.

Economic pundits, too, report economic forecasts with little reference to the inevitable uncertainty that surrounds them.

Why do we accept poll results, but refuse to believe Treasury’s best estimates?

Treasury is very open about the confidence intervals that surround its point estimates, publishing “fan charts” which show the range of possible outcomes around the forecasted one.

For example, last year’s mid year budget update forecast a budget deficit for this coming financial year of 2 per cent of GDP. Does that mean it will happen? It’s unlikely.

A separate fan chart shows Treasury is 90 per cent sure, based on past forecasting errors, that the actual result will lie somewhere between a deficit of nearly 5 per cent of GDP or a surplus of nearly 1 per cent of GDP.

Unhappy with that? You probably yell at the weatherman too.

Treasury will present the budget forecasts in three weeks having just had another internal review of its forecasting process, this time by Warren Tease, a former UBS investment banker hired to Treasury’s Sydney office.

In a recent speech, Mr Tease summed up the challenge thus: “Economic forecasting is hard. The future is mostly unknowable so forecasts will often be wrong. This is particularly the case when we are confronted with the types of unprecedented circumstances that we have seen over the past decade.”

Past reviews have found Treasury has had particular trouble forecasting changes in prices the economy. It’s pretty good at forecasting activity levels, but when it comes to translating this into dollar, or “nominal” terms, it has fallen wide of the mark – as most forecasters have.

Treasury failed to predict the large structural decline in inflation in the 1990s and ended up overestimating GDP as a result. During the mining boom, it failed to foresee the massive ramp up in commodity prices, and hence consistently underestimated nominal GDP.  Because everyone pays their taxes in nominal, or dollar terms, this meant revenue estimates were always too low – allowing Treasurer Peter Costello to do his rabbit in a hat trick of plucking budget surpluses from nowhere.

Similarly, since the mining boom, Treasury failed to forecast the steep decline in prices, leading to overly optimistic revenue forecasts.

So, how much confidence can we have in Treasury’s forecasts? The answer is about as much confidence as we can have in any economic forecast.

If it helps, Treasury don’t write its forecasts on the back of an envelope. There is a rigorous behind the scenes process to produce the numbers you will see on budget night.

Treasury employs around 40 people to produce its global and domestic macroeconomic forecasts.

The process kicks into gear every three months with the Bureau of Statistics’ national accounts data dump.

The latest accounts for the December quarter were released a little over a month ago. As soon as they got them, Treasury’s forecasting subgroups, including on consumption and dwelling investment, labour markets and income, exports and imports, began feeding the numbers into their equations to produce preliminary forecasts.

They presented them internally and then to a meeting of the Joint Economic Forecasting Group – a high level pow-wow between the chief forecasting geeks of Treasury, the Reserve Bank, the Bureau of Statistics and the departments of Prime Minister and Cabinet and Finance.

But that’s not the end of it.

Ever since, Treasury has been running new iterations of its forecasts regularly, taking in new data that comes out, like the most recent jobs figures.

In the coming weeks, Treasury officials will also keep a watchful eye on the currency and on spot prices for the key commodities of iron ore, coal and oil. A “recent average” will be taken and built into the forecasts – usually an average of the four weeks prior.

Sometime in the week before the budget, Treasury’s macro forecasting group will finalise the numbers and send them to the revenue group, which builds the revenue forecasts from them.

They won’t be perfect. But you should have confidence that they’re the best available.

This story Administrator ready to work first appeared on Nanjing Night Net.