How Difficult Is It to Predict the Economy and Why Bother Anyway?

Couple of days ago I came across a study that made me ask myself the question ‘hoe difficult is it to predict the economy’.

I realise that one reasonable response to this question is ‘why we care, anyway’. Before I tell you how, I believe, expectation regarding the economy affect our lives – and therefore predictions of economic conditions are important – let me tell you about the study I found.

This study was carried out by ETX Capital and used Government statistics about GDP Growth Rate, CPI Inflation and the Sterling Index over three years. What the study aimed to achieve is awareness of how the top City, and non-City, firms fare when it comes to their predictions. These predictions, mind, are founded on complex economic analysis and econometric models.

What did the study find?

All companies that were studies were some way off the mark when it comes to predicting these three key indicators for the health of the economy. Some, like Morgan Stanley, Capital Economics, Commerzbank, Centre for Economics and Business Research (CEBR), Oxford Economics and PricewaterhouseCoopers (PWC) had the most accurate predictions each year; still, these predictions were more like guessing the general direction than spelling out the exact distance to a destination.

Predicting the development of the economy, just like predicting the price of Bitcoin in the next two hours, is hard.

It is hard not because of incompetence and lack of good will; it is hard because of five inherent problems mainly related to level of complexity, information deficiency and the unpredictability of ‘black swan’ events. These problems also play when conducting value stock analysis.

Now, you may be getting impatient to hear why this matter (or whether it matters).

In my mind, having some idea about the direction of the economy has three kinds of consequences for our finances and the decisions we make about our money.

Inflation rate predictions and our money

I’ve heard personal finance gurus saying that we shouldn’t get too interested in the inflation rate because it is calculated using consumer items we don’t have to buy all the time.

Now this is a lame advice, if I ever heard any. Go tell my Dad that you shouldn’t be concerned about the inflation rate! He lived through the hyper-inflation in Eastern Europe (in early 90s) and saw his savings shrink from the value of a large apartment to three ice-creams. I’m not even exaggerating (and the apartment was supposed to be for me, so I got the ice cream). You don’t want to live through times when a loaf of bread costs three kilos of dollars; trust me.

With no further ado, here is why knowing what the expected inflation rate would be (or at least the direction it may move in) is important for managing your money. In brief, it affects:

  • Decisions regarding balance of cash to other assets. (Higher inflation means reducing the cash in your portfolio.)
  • Decision whether to pay off your mortgage early (Raising inflation means no.)
  • Selecting your investment vehicle.
  • Calculating your investment returns.

There is more at stake, but this are few examples.

Economy growth

Okay. I’d say this is non-problematic when it comes to its links to our money.

High economic growth is the tide that pushes up all boats. This means more jobs, decent pay, investment growth, dividends, more and better public services and generally better life.

It is true that there is not much we can do to change the situation if the prediction is for very low, or even negative, growth, but at least we can brace ourselves and learn to ride the storms of economic adversity.

Currency index

This tells you the relative standing of your native currency in relation to other currencies.

In more practical terms, knowing the predictions for your native currency index will help you form expectations regarding the way prices of imports will go (including petrol) as well as assist you in planning your travel and vacations.

In summary…

Keeping abreast with the prediction regarding the direction of the economy is important and help us manage our money more effectively.

It is another point entirely that most economic forecasts are sufficiently precise to glimpse direction but not enough for firm planning.

Hence, allowing lean way in your finances, remaining flexible and hedging against adversity is the best you can do.

Have the broader trends in the economy affected your life and how?

photo credit: Alex E. Proimos Cien Pesos via photopin (license)

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