Policy decisions are made now for a time that has not yet arrived. Implicit and explicit forecasts, based on theorised relationships calibrated on past observations, are the tools policymakers use to inform these decisions.
However, forecasts of the future are almost certainly going to be wrong, because the future is seldom exactly like the past. Policy decisions made on the wrong information could therefore also be wrong. Even then, some decisions are more wrong than others, some mistakes have more important implications, and some decisions are more difficult to come back from than others.
The post-global financial crisis period was characterised by persistent underperformance in global GDP compared with forecasts. The IMF’s GDP forecasts were revised lower consistently from 2011 to 2017 as economists the world over adjusted their view of what growth was compared with what they had thought it would be.
Understandably, forecast models based on pre-crisis relationships failed to capture changes in how economies worked. This consistent one-directional error in expectations led to some profound policy mistakes, the results of which continue to affect the SA economy to this day.
Like their global peers, local policymakers also overestimated GDP growth. Potential GDP growth estimates fell to just under 2% by the end of 2019 from just under 4% in 2010. Forecasters also persistently overestimated the consumer price index (CPI) from 2016, with long-term CPI expectations collapsing from about 6% in 2016 to a little over 4.5% by the end of 2019.
In the decade to 2019 the National Treasury set fiscal policy for a larger economy, and higher tax revenues, than what actually transpired. Recurring one-directional errors over multiple years compound, and an annual two-percentage-point error cumulates to a huge 22% error over 10 years. This phenomenon partially explains our current fiscal difficulties.
The SA Reserve Bank also fell foul of this one-directional error as it navigated the heightened political risk from late 2015 to early 2018. Policy rates from 2017 to 2018 were arguably calibrated for a far more inflationary economy than that which transpired. As a result, CPI was below the 4.5% inflation target throughout 2019, even though GDP was below potential. The Bank would have no doubt preferred a narrower output gap and been satisfied with slightly higher inflation.
The 2020/2021 Covid-19 crisis, with its lockdowns, differential vaccination rates and unorthodox fiscal and monetary policy responses across economies, is unprecedented. However, policymakers still use quantitative forecasting models based largely on pre-crisis economic relationships, which are at best compromised and at worst useless, because they don’t have a choice. Similar to what happened after the global financial crisis, the room for policy error is consequently very high, and judgment is critical.
Policymakers have to decide which policy mistakes they really do not want to make, which risks they are willing to tolerate, and make the necessary trade-offs. For example, both fiscal and monetary authorities in the US are sitting squarely on the pro-growth, pro-employment side of the growth/inflation trade-off.
If its most recent budget is anything to go by, the Treasury is pushing hard for an improvement in fiscal sustainability and is willing to take on more fights on the political economy — if the public-sector wage battle and the withdrawal of social support programmes are an indication. After extreme rate cuts and liquidity injections in 2020, the Bank seems to have moved back to its trademark conservatism and orthodoxy across monetary and other areas of policy within its purview.
Given the huge negative employment shock of Covid-19, the wide output gap and the growth-negative bent of fiscal policy, I hope the Bank decides to lean into growth in its future reaction function, and only react to inflation if and when it emerges. Its quarterly projection model, which forecasts that rates should be hiked 50 basis points by the end of 2021, is based on a world that no longer exists. Let’s ignore it.
• Lijane works in fixed-income sales and strategy at Absa Corporate & Investment Banking.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.