- The Washington Times - Sunday, October 11, 2009

You don’t need an economist to know which way the wind blows; a weatherman might do just as well.

Economic forecasting, never a precise science, can be devilishly difficult, particularly when the economy arrives at a turning point.

“Economists never professed to be precise forecasters,” said Peter Morici, a business professor at the University of Maryland who warned about the housing bubble long before it burst. “People ask us, so we forecast. But it’s not a physical science.”

Reaction from Wall Street can compound the problem. The stock market recently has been buffeted by hopes that the economy is climbing out of a hole - or by fears that it is falling back into one, depending on the news of the day.

On Oct. 1, the day after the Dow Jones Industrial Average recorded its best quarterly performance since 1998 and its biggest third-quarter jump since 1939, the Bureau of Labor Statistics reported at 8:30 a.m. that first-time claims for jobless benefits increased during the previous week by 17,000, more than economists expected.

That disappointed investors, who promptly hit the sell button when the stock market opened an hour later.

By 10 a.m., the Institute for Supply Management (ISM) reported that the nation’s struggling manufacturing sector expanded for the second month in a row in September. Economists had expected the pace of expansion to accelerate, but in fact it eased a bit, further disappointing investors.

The rout was on. Not even August’s biggest monthly jump in consumer spending in nearly eight years, which the Commerce Department announced that morning, could take the sting off the unexpected blows on jobless claims and manufacturing. The Dow ended the day down 203 points; all 30 companies in the index retreated.

Exceeding the expectations of economists can move markets the other way as well.

On Oct. 5, the ISM reported that the nation’s service sector expanded in September for the first time in more than a year. The group’s index of non-manufacturing activity jumped from 48.4 in August to 50.9, significantly beating the expectations of 70 economists polled by Bloomberg News.

The subsequent market rally lifted the Dow to a 112-point gain by the closing bell.

Forecasting becomes especially challenging at the economy’s turning point. “It’s one thing to say there is a housing bubble, quite another to say when it will burst,” Mr. Morici said.

Economists have widespread agreement on this point, if nothing else.

“When we approach the turning point in a business cycle, we face the greatest amount of confusion,” said Bernard Baumohl, chief global economist for the Economic Outlook Group.

When the economy is in recession, most indicators point to contraction. When the economy is growing, the indicators point to expansion.

“At the top and bottom of the cycle, you get both - good news and bad news as the economy switches tracks,” Mr. Baumohl said.

Historical trends play a major role in these projections.

“Economic forecasts are based on history where the past is an indicator of the future. But turning points are the complete opposite,” said John Silvia, chief economist at Wells Fargo Securities. Turning points are often accompanied by “shocks to the system,” which render the historical data irrelevant to the future.

Stock-market volatility often reflects new information on the economy that differs from what investors expected. At the turning point, the data also often send conflicting signals, Mr. Silvia said.

“There is a domino effect at the turning point,” Mr. Morici said. “Expectations, which are hard to quantify, can snowball.”

Gas prices can trend upward for months or years, he said. But it is difficult to pinpoint precisely when the trend would move consumers en masse to replace their domestic sport utility vehicles with fuel-efficient imports. Once the snowball effect is triggered, it could send the U.S. economy into the tank or turn a normal downturn into a steep, prolonged slump.

Although the economy’s turning point is traditionally difficult to pinpoint, economic forecasters generally perform better at gauging the depth of the downturn. But that was not the case for the latest recession, which proved to be far more severe than most economists expected.

Mr. Baumohl pointed to “the very unusual business cycle,” which began with a collapse in housing values, proceeded to a full-fledged, worldwide banking crisis and culminated in the biggest drop in employment since the Great Depression.

“Nobody was able to fully anticipate how severely damaged the financial system was both here and around the world,” Mr. Baumohl said. “When the banking sector is nonfunctioning, all forecasting bets are off.”

Nor did economists “appreciate how interconnected the world financial markets were,” said Mr. Silvia, noting the tentacles that linked Lehman Brothers, the bankrupt investment bank, with the rest of the world. U.S. mortgage-backed securities, which were marketed to institutional investors around the world, proved to be very difficult to trade when the subprime-mortgage crisis hit in the summer of 2007.

“Nobody had a handle on it,” said Mr. Morici.

Reliance on statistical forecasting models before the recession struck was “fraught with great risk because these models could not forecast the real estate collapse and the banking failures,” Mr. Baumohl said.

“Mathematics has given economics great rigor,” Mr. Baumohl said, “and mortis.”

But based on postwar experiences, which did not include any nationwide housing collapse, the models were too rigid. “What we faced was a once-in-a-century crisis,” said Mr. Baumohl, who acknowledged that he now relies increasingly on roundtable discussions to forecast the economy.

“When data you are observing is outside historical experience, the precision of a forecast drops dramatically,” Mr. Morici said.

It was one thing when the price of oil jumped from about $50 per barrel in January 2007 to about $100 per barrel in December 2007, when the recession officially began. “Nobody ever saw the price of oil above $145 a barrel,” where it peaked in July 2008 and sent gasoline prices above $4 per gallon.

Gus Faucher of Moody’s Economy.com said economists would continue to rely on mathematical models, noting that the “Great Recession” has added a load of data points that were previously not part of their historical trends.

The extra information may help to project the depth and breadth of future downturns. But it cannot alter the less-than-dire forecasts in 2007 for what later proved to be the deepest and longest U.S. recession since the Great Depression.

“This is a period of soul-searching for economists, it’s fair to say,” Mr. Faucher said.

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