From the TUC

GDP, inflation and optimism bias

29 Jan 2016, by in Economics

January contains a number of key dates: New Year’s Day is obviously a big one, blue Monday (the day which some deeply dubious psychology has identified as the most depressing of the year), and it heralds the first release of the fourth quarter and thus calendar year GDP figures for the previous year.

GDP results are released four times throughout the year (leaving aside revisions for the moment) but these results provide an initial summation of the year before.  As a result it can be instructive to compare the annual GDP figure with past predictions of growth.

Helpfully, the Treasury provides a monthly summary of economic forecasts from a range of city and non-city institutions. Yesterday the ONS published figures that put the growth for calendar year 2015 in GDP at 2.2%. That’s a material reduction from the 2.9% witnessed in 2014.

The first time predictions for 2015 are featured in the summary of forecasts is February 2014. City forecasters average a predicted growth rate of 2.5% with a couple of particularly bullish city institutions forecasting 3.2% and 3% respectively. Non-city forecasters were more circumspect, though they still average 2.4%.

In March the OBR released a more cautious prediction of 2.3% but this didn’t stop the average in November hitting 2.6%. By December 2014 the average prediction for growth in the following year had returned to the February rate of 2.5%, no one was predicting 3.2% any more, but predictions of 3% by city forecasters and 2.7% by non-city institutions were also common. The OBR, for their part, closed the year with a forecast of 2.4% growth in GDP over 2015.

If we turn to inflation forecasts the trend is starker. The charts below provides the average 2015 inflation level as forecast throughout 2014 and 2015, along with the actual level of inflation:

Predicted inflation:

average of independent forcasts for 2015

Actual inflation:

Actual inflation 2015

As you can see the year started out with high expectations for both RPI and CPI inflation. By December this optimism had begun to moderate and the predicted inflation rate for both measures declines sharply at the end of the year. Nonetheless, predicted RPI inflation closed out 2014 a shade above 2.6% for Q4, CPI closed at about 1.7% over the course of 2015 forecasters came to realise how optimistic their previous predictions had been.  Predictions for August of 2015 put CPI inflation at 0.5% and RPI a little above 1%; in actual fact CPI barely scrapped above 0 in August having gone negative earlier in the summer. It was only for the months of November and December 2015 that the optimistic outlook really begins to falter sufficiently for forecasts to begin to align with actual inflation rates.  ONS figures indicated a small rise in CPI in Q4 2015: from 0.1% to 0.2%. RPI inflation hit 1.2%, up from 1.1% the month before. For most of the period covered, even when pessimistic, predictions went significantly above the actual figure.

This allows me to segue neatly into a little diatribe about cognitive biases, and in particular my favourite: Optimism bias. Optimism bias is the habit of believing that the future will be significantly better regardless of available evidence to the contrary. When asked students generally over-estimate their chance of earning a high salary and most people underestimate their chances of getting divorced, despite widely reported statistics indicating that really quite a lot of people experience the later, and very few receive the former.

You might ask if all this is really a problem. A few tenths of a percentage, even a pecentage point here and there is surely not indicative of incipient crisis? Well the problem comes when observers allow optimism bias to sway their interpretation of the figures. For example, as this statement from Frances O’Grady indicates, the recovery described in yesterday’s release is shakier than the headline number implies. Construction figures dropped by 0.1% following an unnerving drop of almost 2% in Q3. Manufacturing was either stagnant or falling throughout 2015, and the fact that it is currently stagnant is probably not cause for celebration. What growth we have had comes from the service sector. The strongest quarterly growth (1.1%) came from Distribution, Hotels and Restaurants; an industry marked by instability and low wages. There is evidence that an over-reliance on this type of employment can mar the prospects of young people for the rest of their working life.  It is also a sector that is particularly vulnerable to an economic downturn, as consumers cut down on luxuries like eating out and going away.  Bear in mind the reliance on the service sector and the headline of 2.2% begins to look distinctly rocky, particularly when we compare it to the comparatively ebullient figure we saw the year before.

Overall, optimism bias is probably a good thing: a future where nobody ever got into a relationship because statistically it was likely to fail would look pretty bleak for the species. However, when it comes to economics, some judicious scepticism is needed.  An overly optimistic attitude might lull us into failing to take the kind of actions our economy really requires. A recovery built on low-paid, zero hours service industry is likely to take a real battering should consumer confidence fall and spending on services dry up. We need a stronger recovery that extends to all sectors of the economy. The weakness of manufacturing and construction is no surprise given the government’s lack of a proper industrial policy to boost the economy and protect crucial industries like steel. Without it, the economic outlook could well become bleaker.

4 Responses to GDP, inflation and optimism bias

  1. Mr Hasan Abdulla
    Jan 30th 2016, 7:26 pm

    Well presented and well argued, Kam Gill. We certainly do need policies that will benefit all sectors of the economy. I can only add here the slogan “From each according to their ability to each according to their need.” This principle and not austerity ought to be the key to economic recovery.

  2. Ron
    Jan 31st 2016, 7:41 pm

    Agree with Hasan

    However, under neo-liberal (fascist) policies all that’s going to happen is the poor will continue to get poorer and die and the rich will reap the benefits, as usual. Remember the only interesting financial state is that of the rich and multinationals – the rest of us are surplus to requirement – just as it’s meant to be …..

  3. Ron
    Jan 31st 2016, 7:47 pm

    can I add –

    there is no effect opposition in this country to the neo-liberal mendacity of the current government and previous labour governments. The TUC is certainly not in the vanguard of challenging government. Indeed, disabled people have been left to fight alone in this country by the workforce, the unions, the labour party and the charities – a difficult task for the most vulnerable group in our nation – but at least they give it a go rather than wait for others. It is f***ing shameful that nobody cares enough to get involved.

  4. Shaun Cohen
    Feb 1st 2016, 10:32 am

    Yet more evidence thatthe so called recovery is anything but. Are we doomed it appears so. The BRIC economis in all sorts of trouble, continuing scandal over lack of housing and the latest Govt initaive on this is ridiculous. Continued disappearance of manufacturing from the economy, no alternative in sight.