Chapter 7

Forecasting
Forecasting is simulation applied to the future. This chapter describes the basic types of forecasts, how to forecast and how to evaluate the accuracy of forecasts.

Types of forecast
Macroeconomic forecasting takes advantage of two things: the inherent persistence of economic variables, and knowledge of how the economy is affected by various external factors such as economic policy. Forecasts that only use the persistence of economic variables are called unconditional forecasts. They are not conditioned on some external factor. In contrast, a conditional forecast ties the forecast to some condition of the external factors. For example: If the oil price goes up next year, there may be a recession next year. r, if the government reduces income taxes there may be an increase in !"# next year. The future is never perfectly predictable so forecasts are sub$ect to forecast errors. The uncertainty of the forecast may be expressed by forming a forecast confidence interval in which we have a certain degree of confidence. For example: I feel %& percent certain that unemployment will lie between ' and ( percent in the next year. "epending on the situation, the forecast interval may be small ) revealing a large confidence in the forecast* or wide, revealing a low confidence. Typically, the longer the forecast horizon, the period over which we make the forecast, the greater the uncertainty. Forecasting is almost synonymous with predicting the future, a so called ex ante forecast. In principle, we can also go back to a date in the past and make a forecast forward in time, a so called ex post forecast as depicted in Figure %.+. ,uch a forecast can be compared to what actually happened. -.e actually discussed this as a trend model evaluation method./

0x post forecast

0x ante forecast Time

0stimation period

Today

Figure 9.1. 0x ante and ex post forecasts.

Constructing conditional and unconditional forecasts

Formal macroeconomic forecasting uses econometric models to simulate the future. Technically, forecasting is $ust simulation applied to the future. "epending on the type of model we use, we construct unconditional or conditional forecasts. .ith unconditional forecasts, we do not assume anything in particular about the future. This is also called non-structural forecasting. .e do not make specific assumptions about the setting of policy instruments for example. This is possible only with pure time series models that do not contain exogenous variables. !iven initial values of the variables, we can simulate into the future by setting the shocks e1ual to their expected values, that is, 2ero. .e can use single e1uation 34M3 or 34IM3 models, or multivariate 534 or 506 models. .hen the model is in first difference form, that is, 34IM3 or 506, we simulate the future changes and then add the changes to the initial levels. The reason for calling the approach non7structural modelling is of course that the models are non7structural. 3s an example, suppose we have estimated an 34-+/ process to describe ln!"# minus a linear logarithmic trend, i.e., the business cycle. The best guess of the next period8s cyclical lnGDP is then the lnGDP predicted by the model when we use today8s lnGDP on the right7 hand side. 9y definition, we expect the error to be 2ero and we exclude it from the forecast. For the forecast of lnGDP two periods from now, we use the lnGDP forecasted for the next period as the right hand side variable, and so on. Thus, we simulate the deterministic part with today8s lnGDP as the initial value. .e perform a dynamic deterministic simulation into the future when we forecast by setting the unknown error terms to 2ero. To forecast actual

ln!"#, we add the cyclical ln!"# part to the forecasted logarithmic trend. ver time, cyclical ln!"# will approach 2ero since there no new shocks -known by us/ and long7 run forecasts will approach the forecasted trend. The best forecast we can make for the long run is the forecasted trend value. Conditional forecasts are conditioned on some assumption about the future. .e use a structural model with explicit exogenous variables, thereof the name structural forecasting. ,ince the model does not explain the exogenous variables, we must assume something about them. ,tructural forecasting is relevant when we think there will be some change in a variable that is not captured by its historical evolution as described by its time series properties. The typical case is the analysis of the effects of changes in policy instruments. #olicy makers may want to simulate the future under different settings of their policy instruments to find out the best policy. For example, central banks aim to stabili2e inflation at some low level. They make forecasts under different settings of their policy instrument to find the setting that keeps the inflation rate on track. For pedagogical reasons, some central banks which target the inflation rate present a forecast based on keeping the policy instrument unchanged. If the forecast points to higher inflation than the target, they begin a contractionary policy. The actual change in the policy instrument is then based on a forecast that shows that this particular change will keep the inflation rate on track. #rivate forecasters may also want to use conditional forecasts because they have some foreknowledge of a policy change, perhaps because the policy makers have credibly declared that they will behave in a certain way. 6learly, they would like to take into account that information. For this a structural model showing the effect of policy must be used.

Measuring forecast uncertainty

.hat confidence can we put in the forecasts: Forecast evaluation measures use various measures of how close the forecasts are to the actual outcome. The most common is the so7 called 4oot Mean ,1uare 0rror - !"#/ criterion defined by:

!"# i =

+ $ y t t i y t f n t =+

where

t i

y tf is the forecast made i periods before t. Thus we compute different !"#<s for

different forecast hori2ons. The !"# is the standard deviation of forecast errors. =sually, we are not $ust interested in comparing forecasts from different models for a specific variable, but we also want a sense of how large the forecast errors are. ,ince the !"# uses absolute deviations which si2e depends on the units of y, it is more informative to compute the !"# of relative deviations:

elative !"#i =

+ $ y t t i y t f y n t =+ t

4ecall, however, that relative deviations can be measured as absolute differences of logarithmic values. Thus if our models is in logarithms, we $ust calculate the !"# with absolute deviation of logarithms. To compute the !"#, we need in principle both actual and forecasted values. For linear, single7e1uation models it is possible to derive the forecast uncertainty analytically. The !"# for one7period forecasts is simply e1ual to the standard deviation of the estimated errors -the standard error/. ,pecial formulas are available for longer forecast !"#8s. For more complicated models it is, however, not possible to derive analytical formulas. Instead, we may use stochastic simulation to generate future actual values and compare them to forecasted values. This techni1ue may of course also be used for models where analytical results are available. Table %.+. lays out the basic techni1ue. .e are interested in the average forecast errors at different hori2ons as measured by 4M,0<s. To do this we need to generate forecasts as well as actual developments. !iven initial values -typically steady state values/, we generate one forecasted path for say % periods into the future. .e then generate a number of hypothetical actual developments of the variable to be forecasted. ,ay we generate & different paths by drawing & sets of random numbers each containing % values. .e can then compute & forecast errors for each forecast hori2on. =sing these & forecast errors we can compute one 4M,0 for each forecast hori2on.

Table 9.1. !enerating 4M,0<s for different forecast hori2ons using stochastic simulation. >ori2on Forecast ,hocks ' yf +i ?
@ i

y paths y+i ?

& i

,1uared forecast errors -y+i 7 yf/; ? -y&i 7 yf/;

4M,0 + & ( y i( y if % ( =+

+ ; ? % %ote: There are & columns with shocks, & columns with actual y paths, one column of forecasts, and & columns of s1uared forecast deviations. The root mean s1uared errors -4M,0/ can be computed as the standard deviations across the & columns

Using forecast errors to investigate the importance of different shock types - Variance decomposition
3bove, we described how to calculate 4M,0<s to measure the forecasting ability of models as forecasting tools. The techni1ue can also be used for structural analysis as a way of measuring the importance of different shocks in explaining the variability of the endogenous variables. The approach can be used for any structural model, but is used particularly for structural 534 models. ,uppose we have a two7variable recursive 534 model with two estimated structural errors. Imagine stochastically simulating the evolution of both variables feeding the model with only one of the shocks using the estimated standard deviation of that shock. 6alculate the 4M,0 for different forecast hori2ons as given in Table A.+. Then do the same for the other shock. Then you can compare the relative importance of the two shocks at different hori2ons. It may be that one of the shocks explains most of the variation for short hori2ons, while the other explains more of the variation in the long run. ften the result is given in a table like Table %.; with variances instead of 4M,0<s -standard deviations/. Then it will be the case that the sum of the variances adds up to the total variance of that variable when the model is simulated with both shocks. Thus, for a two7variable system the total forecast variance of variable y+ is e1ual to the sum of the variance in y+due to shocks in y+ and the variance in y+ due to shocks in y;.

Table 9.2. 5ariance decomposition of a two7variable structural 534 >ori2on + ; ? % %ote: The variance decomposition is based on stochastic simulations as in Table A.+ of a recursive 534 with one shock at a time. 5ariance in y+due to ,hocks in y+ ,hocks in y; 5ariance in y+due to ,hocks in y+ ,hocks in y;