Monday, June 19, 2017

Forecast stability (unemployment rate edition)

I have an old post where I proposed a though experiment: What would the charts of economic forecasts look like over time if they were made with the incorrect model?

Well, the FRBSF has revised their unemployment rate forecast once again in the latest issue of FedViews so I went back and compiled their forecasts from the beginning of 2015, 2016, and 2017 (shown in different colors below) into a single chart reminiscent of the thought experiment charts. Basically, the FRBSF has continued to revise their forecast for the unemployment rate downward over time.

In addition to compiling those forecasts, I made forecasts using the dynamic equilibrium model (gray) from the same starting date as the FRBSF forecasts (shown with a vertical gray line).

Here are the results:

While, yes, the dynamic equilibrium model does pretty well in terms of residuals, I wanted to bring attention to another desirable quality of models: the dynamic equilibrium forecasts are relatively stable with respect to incoming data (and in fact converge over time).

Now it is true that the unemployment rate will almost inevitably go up again at some point in a future recession. And recessions do introduce some instability into the dynamic equilibrium forecasts of the unemployment rate (as you can see in the algorithmic recession detector), but that instability occurs exactly where we should tolerate it more: a dynamic non-equilibrium situation like a recession. The FRBSF instability occurs during what we'd otherwise consider a "normal" economy.

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