Why big fiscal deficits and low inflation can coexist

• ▀ The surge in government debt caused by ballooning fiscal deficits is a necessary response to the coronavirus crisis. But we doubt this will lead to a burst of inflation in the advanced economies (AEs), let alone a debt crisis.
• ▀ Our fiscal forecasts assume AEs’ budget deficits averaged 20% of GDP or so in Q2. However, our deficit forecasts point to a sharp narrowing thereafter and for public debt as a share of GDP to peak in 2021.
• ▀ The risks around this forecast skew firmly towards deficits remaining wide, reflecting the balance of risks around our GDP forecasts and the possibility that governments allow some fiscal slippage.
• ▀ A slower narrowing of fiscal deficits than we forecast wouldn't automatically lead to a period of above-target inflation. Indeed, we wouldn't be surprised if larger-than-expected deficits were associated with weak inflation.
• ▀ High levels of corporate debt and weak labour markets raise the risk of private sector retrenchment ahead. In that case, large and sustained fiscal deficits may be needed to fill the vacuum and prevent GDP and inflation from falling. As has been the case in Japan over the past 25 years, large deficits over coming years could be associated with weak GDP growth and below-target inflation.
• ▀ If economies begin to overheat but governments keep fiscal policy loose, inflation could, of course, pick up. But central bank tightening would offset it. We believe the risk of sustained inflation overshoots is limited unless monetary policy were made subservient to governments’ own objectives. And we think the risk of central banks losing independence remains slim.

     

Demographic forecasts and fiscal policy rules

All quantitative evaluations of fiscal sustainability that include the effects of population ageing must utilize demographic forecasts. It is well known that such forecasts are uncertain, and some studies have taken that into account by using stochastic population projections jointly with economic models. We develop this approach further by introducing regular demographic forecast revisions that are embedded in stochastic population projections. This allows us to separate, for each demographic outcome and under different policy rules, the expected and realized effects of population ageing on public finances. In our Finnish application, demographic uncertainty produces a considerable sustainability risk. We consider policies that reduce the likelihood of getting highly indebted and demonstrate that, although demographic forecasts are uncertain, they contain enough information to be useful in forward-looking policy rules.     

Efficient forecast tests for conditional policy forecasts

Central Banks regularly make forecasts, such as the Fed’s Greenbook forecast, that are conditioned on hypothetical paths for the policy interest rate. While there are good public policy reasons to evaluate the quality of such forecasts, up until now, the most common approach has been to ignore their conditional nature and apply standard forecast efficiency tests. In this paper we derive tests for the efficiency of conditional forecasts. Intuitively, these tests involve implicit estimates of the degree to which the conditioning path is counterfactual and the magnitude of the policy feedback over the forecast horizon. We apply the tests to the Greenbook forecast and the Bank of England’s inflation report forecast, finding some evidence of forecast inefficiency. Nonetheless, we argue that the conditional nature of the forecasts made by central banks represents a substantial impediment to the analysis of their quality—stronger assumptions are needed and forecast inefficiency may go undetected for longer than would be the case if central banks were instead to report unconditional forecasts.     

How likely is a UK recession after Brexit?

• In the wake of the UK Brexit vote, forecasters have rushed to downgrade their growth forecasts for the UK, with some now expecting a recession. Using the Oxford Economics' Global Economic Model, we examine how likely a recession is by looking at the shocks the UK economy faces and the policy responses. We conclude that while a sharp slowdown is likely – in line with our own new forecasts – a recession is unlikely.
• Many UK forecasters are now predicting a recession in 2017, even though ‘stand‐alone’ recessions in industrial countries are rare. Our forecast is less downbeat. The UK faces a series of negative shocks including to consumers and business confidence, but growth will be supported by the weaker sterling and likely policy responses.
• Using the Oxford Economics' Global Economic Model, we show that to shift our baseline forecast of growth of 1.1% next year to zero would require a very severe negative confidence shock. Our new baseline already assumes a shock equivalent to one‐third of that seen in the global financial crisis (GFC). All else being equal, the shock would have to be around two‐thirds of that in the GFC to cut GDP growth to zero in 2017.
• Our new baseline also does not incorporate all the possible policy levers the UK can employ. We currently assume the Bank Rate drops to zero, but if a ‘rescue package’ of £75 billion of QE and a fiscal stimulus equal to 1% of GDP was also added, then the shock to confidence needed to get zero GDP growth would have to be similar to that seen in the GFC. We do not consider this likely given the scale of financial stress and credit restriction that occurred globally at the time of the GFC.

     

Fiscal policy and asset markets: A semiparametric analysis

Using a flexible semiparametric varying coefficient model specification, this paper examines the role of fiscal policy on the US asset markets (stocks, corporate and treasury bonds). We consider two possible roles of fiscal deficits (or surpluses): as a separate direct information variable and as a (indirect) conditioning information variable indicating binding constraints on monetary policy actions. The results show that the impact of monetary policy on the stock market varies, depending on fiscal expansion or contraction. The impact of fiscal policy on corporate and treasury bond yields follow similar patterns as in the equity market. The results are consistent with the notion of strong interdependence between monetary and fiscal policies.     

THE AUTUMN STATEMENT

The Treasury's forecasts, published with the Autumn Statement, are close to those we presented in October. For domestic demand the main difference is that the Treasury has consumption growing by 3 per cent next year whereas we had forecast a growth of only 2 percent. Behind this difference lies a significant different in policy assumptions. In October we estimated that there was no scope for tux cuts, yet the Treasury's forecast assumes that there will be net cuts in taxation (over and above indexation) of £11/2bn in the next Budget. In this Forecast Release we show that the main differences are (a) that the government has raised its forecasts of sales of assets and council houses arid (b) that it expects more North Sea Oil Revenue than we do. The latter forecast depends critically on what happens to the exchange rate.
We present a revised forecast based on the new information in the Autumn Statement and incorporating the £1 1/2bn tax cuts. It is very close to the Treasury's forecast.
We also discuss the relevance of changes in North Sea oil revenue to fiscal policy and we suggest that it is misleading to treat it on a par with other sources of revenue. We then show that the suggested tax cuts of £11/2bn in the next Budget are effectively £4bn less than was indicated last March. Finally we argue that the Chancellor's claim to have kept within his Planning Totals for spending in the last three years has only been achieved by increased asset sales.     

Evaluating the sustainability of Italian public finances

Are Italy’s primary-surplus policies compatible with the sustainability of government debt? We address the question by examining historical budget data in post-unification Italy, from 1861 to 2016. Controlling for temporary output, temporary spending and world war-time periods in assessing whether primary surpluses significantly reacted to changes in debt, we find the following results: (i) the hypothesis of nonlinearity in the surplus-debt relationship significantly outperforms the hypothesis of linearity; (ii) there exists a threshold level in the debt-GDP ratio, approximately equal to 105 percent, above which Italian fiscal policy makers are concerned with corrective actions to avoid insolvency; (iii) the robustly positive reaction of primary surpluses to debt beyond the trigger point ensures fiscal sustainability.     

Forecast Bias and MSFE Encompassing

We show that the standard condition for MSFE encompassing is no longer valid when the forecasts to be compared are biased. We propose a simple modification of such a condition and of tests for its validity. The theoretical results are illustrated by an empirical example on inflation and deficit forecasts, key variables for the formulation of monetary and fiscal policy.     

How accurate are government forecasts of economic fundamentals? The case of Taiwan

A government’s ability to forecast key economic fundamentals accurately can affect business confidence, consumer sentiment, and foreign direct investment, among others. A government forecast based on an econometric model is replicable, whereas one that is not fully based on an econometric model is non-replicable. Governments typically provide non-replicable forecasts (or expert forecasts) of economic fundamentals, such as the inflation rate and real GDP growth rate.In this paper, we develop a methodology for evaluating non-replicable forecasts. We argue that in order to do so, one needs to retrieve from the non-replicable forecast its replicable component, and that it is the difference in accuracy between these two that matters. An empirical example to forecast economic fundamentals for Taiwan shows the relevance of the proposed methodological approach. Our main finding is that the undocumented knowledge of the Taiwanese government reduces forecast errors substantially.     

ESTIMATING FISCAL LIMITS: THE CASE OF GREECE

This paper uses Bayesian methods to estimate a real business cycle model that allows for interactions among fiscal policy instruments, the stochastic ‘fiscal limit’ and sovereign default. Using the particle filter to perform likelihood‐based inference, we estimate the full nonlinear model with post‐EMU data until 2010:Q4. We find that (i) the probability of default on Greek debt was in the range of 5–10% in 2010:Q4 and (ii) the 2011 surge in the Greek real interest rate is within model forecast bands. The results suggest that a nonlinear rational expectations environment can account for the Greek interest rate path. Copyright © 2014 John Wiley & Sons, Ltd.     

Modelling and Forecasting Fiscal Variables for the Euro Area*

In this paper, we assess the possibility of producing unbiased forecasts for fiscal variables in the Euro area by comparing a set of procedures that rely on different information sets and econometric techniques. In particular, we consider autoregressive moving average models, Vector autoregressions, small‐scale semistructural models at the national and Euro area level, institutional forecasts (Organization for Economic Co‐operation and Development), and pooling. Our small‐scale models are characterized by the joint modelling of fiscal and monetary policy using simple rules, combined with equations for the evolution of all the relevant fundamentals for the Maastricht Treaty and the Stability and Growth Pact. We rank models on the basis of their forecasting performance using the mean square and mean absolute error criteria at different horizons. Overall, simple time‐series methods and pooling work well and are able to deliver unbiased forecasts, or slightly upward‐biased forecast for the debt–GDP dynamics. This result is mostly due to the short sample available, the robustness of simple methods to structural breaks, and to the difficulty of modelling the joint behaviour of several variables in a period of substantial institutional and economic changes. A bootstrap experiment highlights that, even when the data are generated using the estimated small‐scale multi‐country model, simple time‐series models can produce more accurate forecasts, because of their parsimonious specification.     

Planning Feature The Forecast in Detail: (2) Assumptions

We continue to make our best guesses about likely policy developments rather than assuming ' unchanged policies '. This forecast differs from our July forecast in that we have not assumed any income tax cuts; nor have we assumed, as we did in July, that National Insurance contributions would be increased. We do, however, continue to assume the abolition of the national insurance surcharge in two equal stages during the 1984-5 fiscal year, as well as the usual indexation of tax allowances and bands and revalorisation of indirect taxes. This change in assumptions about policy reflects our guess that the new Chancellor, Nigel Lawson, will attempt to hit his monetary targets by a combination of tighter fiscal policy and lower interest rates than we had previously assumed. In this forecast interest rates are on average about 2 points lower than in July.     

Assessing the prudence of economic forecasts in the EU

We estimate the EU Commission loss preferences for major economic forecasts of 12 Member States. Based on a recently proposed method by Elliott, Komunjer and Timmermann (2005) the paper provides evidence of asymmetries in the underlying forecast loss preference of the Commission that tend to vary across Member States. In some cases, our results show that EU forecasts tend to display a rather optimistic picture for main economic variables, e.g. government balance, thus allowing a certain degree of leeway in the fiscal adjustment path towards the medium‐term objective of ‘close to balance’ or ‘in surplus’ of the recently revised Stability and Growth Pact. Over the period of our sample, 1970–2004, this apparent asymmetry in the underlying loss preferences tends to deter prudent advice over economic policy. Lastly, we provide an analysis on the trade‐off between loss and distribution asymmetries, for which simulation results show that the testing method is robust in the presence of skewness. Copyright © 2009 John Wiley & Sons, Ltd.     

Subjective evaluation of composite econometric policy inputs

Studies have suggested that a composite forecast may be preferred to a single forecast. In addition, forecasting objectives are often conflicting. For example, one forecast may have the smallest sum of absolute forecast errors, while another has the smallest maximum absolute error. This paper examines the appropriateness of using multiple objective linear programming to determine weighted linear combinations of forecasts to be used as inputs for policy analysis. An example is presented where the methodology is used to combine the forecasts for several policy variables. The forecasts are selected from large econometric, consensus, and univariate time series models.     

Forecasts in times of crises

Financial crises pose unique challenges for forecast accuracy. Using the IMF’s Monitoring of Fund Arrangements (MONA) database, we conduct the most comprehensive evaluation of IMF forecasts to date for countries in times of crises. We examine 29 macroeconomic variables in terms of bias, efficiency, and information content to find that IMF forecasts add substantial informational value, as they consistently outperform naive forecast approaches. However, we also document that there is room for improvement: two-thirds of the key macroeconomic variables that we examine are forecast inefficiently, and six variables (growth of nominal GDP, public investment, private investment, the current account, net transfers, and government expenditures) exhibit significant forecast biases. The forecasts for low-income countries are the main drivers of forecast biases and inefficiency, perhaps reflecting larger shocks and lower data quality. When we decompose the forecast errors into their sources, we find that forecast errors for private consumption growth are the key contributor to GDP growth forecast errors. Similarly, forecast errors for non-interest expenditure growth and tax revenue growth are crucial determinants of the forecast errors in the growth of fiscal budgets. Forecast errors for balance of payments growth are influenced significantly by forecast errors in goods import growth. The results highlight which macroeconomic aggregates require further attention in future forecast models for countries in crises.     

What are the effects of fiscal policy shocks?

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit‐spending, deficit‐financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955 to 2000. We find that deficit‐financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue 5 years after the shock. Copyright © 2009 John Wiley & Sons, Ltd.     

Forecasting and uncertainty in the economic and business world

Forecasts are crucial for practically all economic and business decisions. However, there is a mounting body of empirical evidence showing that accurate forecasting in the economic and business world is usually not possible. In addition, there is huge uncertainty, as practically all economic and business activities are subject to events we are unable to predict. The fact that forecasts can be inaccurate creates a serious dilemma for decision and policy makers. On the one hand, accepting the limits of forecasting accuracy implies being unable to assess the correctness of decisions and the surrounding uncertainty. On the other hand, believing that accurate forecasts are possible means succumbing to the illusion of control and experiencing surprises, often with negative consequences. We believe that the time has come for a new attitude towards dealing with the future. In this article, we discuss the limited predictability in the economic and business environment. We also provide a framework that allows decision and policy makers to face the future — despite the inherent limitations of forecasting and the uncertainty, sometimes huge, surrounding most future-oriented decisions.     

Least squares learning and the US Treasury bill rate

Understanding how agents formulate their expectations about Fed behavior is important for market participants because they can potentially use this information to make more accurate estimates of stock and bond prices. Although it is commonly assumed that agents learn over time, there is scant empirical evidence in support of this assumption. Thus, in this paper we test if the forecast of the three month T-bill rate in the Survey of Professional Forecasters (SPF) is consistent with least squares learning when there are discrete shifts in monetary policy. We first derive the mean, variance and autocovariances of the forecast errors from a recursive least squares learning algorithm when there are breaks in the structure of the model. We then apply the Bai and Perron (1998) test for structural change to a forecasting model for the three month T-bill rate in order to identify changes in monetary policy. Having identified the policy regimes, we then estimate the implied biases in the interest rate forecasts within each regime. We find that when the forecast errors from the SPF are corrected for the biases due to shifts in policy, the forecasts are consistent with least squares learning.     

Anchoring the yield curve using survey expectations

The dynamic behavior of the term structure of interest rates is difficult to replicate with models, and even models with a proven track record of empirical performance have underperformed since the early 2000s. On the other hand, survey expectations can accurately predict yields, but they are typically not available for all maturities and/or forecast horizons. We show how survey expectations can be exploited to improve the accuracy of yield curve forecasts given by a base model. We do so by employing a flexible exponential tilting method that anchors the model forecasts to the survey expectations, and we develop a test to guide the choice of the anchoring points. The method implicitly incorporates into yield curve forecasts any information that survey participants have access to—such as information about the current state of the economy or forward‐looking information contained in monetary policy announcements—without the need to explicitly model it. We document that anchoring delivers large and significant gains in forecast accuracy relative to the class of models that are widely adopted by financial and policy institutions for forecasting the term structure of interest rates.     

Anticipation,learning and welfare: the case of distortionary taxation

We study the impact of anticipated fiscal policy changes in a Ramsey economy where agents form long-horizon expectations using adaptive learning. We extend the existing framework by introducing distortionary taxes as well as elastic labor supply, which makes agents’ decisions non-predetermined but more realistic. We detect that the dynamic responses to anticipated tax changes under learning have oscillatory behavior that can be interpreted as self-fulfilling waves of optimism and pessimism emerging from systematic forecast errors. Moreover, we demonstrate that these waves can have important implications for the welfare consequences of fiscal reforms.