How Surprises Play a Role in Economic Conditions

Interest rates continue to defy the conventional wisdom and bond guru Bill Gross. The 10-year Treasury began the year yielding 3.36 percent. By March, when Gross announced he had sold all his Treasuries, the yield was around 3.6 percent. On Friday June 24, the yield on the 10-year Treasury rate had fallen to 2.88 percent, its lowest level of the year.

With the conventional wisdom being that interest rates were sure to rise, many investors parked their fixed income assets in very short-term investments. This has proven to be a painful experience, not only because they were earning virtually zero on the investments, but they've failed to take advantage of the term premium available due to historically steep yield curve levels. And now rates have fallen even further.

Getting forecasts wrong is nothing new. For example, in July 2009, The Wall Street Journal asked 50 economic forecasters for their prediction of where the yield of the 10-year Treasury note would be in one year. Only seven even guessed the direction correctly. All the evidence from academic research demonstrates that not only are there no good forecasters, but forecasts tend to be even worse when they are needed most: At the turning points in the economy.

Why do so many smart, sophisticated forecasters get it wrong so persistently? The explanation is simple -- surprises are a persistently important factor in outcomes. And by definition, surprises aren't forecastable.

The explanation for the most recent failure of most forecasters is that almost all the surprises have been on the negative side for the economy. As the New York Times put it: "A drumbeat of disappointing data about consumer behavior, factory sales and weak hiring in recent weeks has prompted economists to ratchet down their 2011 economic forecasts to as little as half what they expected at the beginning of the year."

Certainly this year has been filled with plenty of surprises, including:

• Supply chain disruptions after the earthquake and tsunami in Japan
• A series of revolutions in the Mid East that have disrupted oil supplies, which in turn let to risingoil prices (until just recently)
• The continued fall in housing prices
• Persistently high new claims for unemployment
• Slowing growth in emerging markets like China and India
• The European debt crisis
• The failure to pass an extension of the debt ceiling

The fact that surprises occur with such frequency explains why we so often hear "if only" excuses from forecasters, explaining why they got it wrong.

The following quotations provide insights into the question of whether one should place any value of forecasts.

Ben Bernanke

• As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because the economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.

• In an efficient market, investors will incorporate any new information immediately and fully in security prices. New information is just that: new, meaning a surprise (anything that is not a surprise is predictable and should have been predicted before the fact). Because happy surprises are about as likely as unhappy ones, price changes in an efficient market are about as likely to be positive as negative ... In a perfectly efficient market, price changes are random.

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