Economic Forecasts: Understanding the Basics

When weather forecasts are inaccurate, we can usually alter our plans with little consequence in the larger scheme of things. When economic forecasts are inaccurate, however, the consequences may be more significant. While making financial decisions does involve some guesswork, an educated guess—even with elements of uncertainty—may be better than making a decision with no forecast at all.

Unfortunately, economic forecasting, like weather forecasting, is far from an exact science. Even professional economists may strongly disagree on the direction of the economy at any given point in time, based on their interpretations of conflicting economic indicators. Although many factors are pivotal in assessing the economy, let’s focus on two key points that may help you better understand where our economy currently stands and where it may be headed in the near future.

How Much Longer?

Economic forecasters are always searching for storm clouds that might signal an economic downturn. Since consumer spending has historically accounted for about two-thirds of the economy, many observers have looked to “pocketbook” issues in search of primary clues as to the direction of the economy.

Consumers don’t usually cut back first and cause a recession. Rather, they may buy more on credit, which leads to greater monthly payments. However, at some point, consumers can do only what their incomes will allow. With personal debt on the rise, monitoring consumer debt levels is particularly important because of the impact of total consumer spending on our economy. In addition, it may be wise to heed Federal decisions, which lay the foundation for our overall economic climate.

The Role of the Federal Reserve Bank (the Fed)

Even the casual observer of business news knows that “Fed watching” is a serious activity in the financial and business sectors. You may be wondering, “What makes the Fed so important?”

While consumers can affect the economy by spending according to their own situations and pocketbook pressures, Federal policy decisions, such as fiscal and monetary measures, can also affect the economy. Fiscal policy, enacted by Congress in the form of tax and/or spending legislation, is the result of the political process and the prevailing political climate. In contrast, monetary policy is the responsibility of the Fed, whose role is to evaluate all factors influencing the economy (individual, market, and government) and to take the action it believes will keep the economy on an even keel.

The Fed can manipulate the flow of money in order to obtain a desired effect over time. However, the Fed’s most effective short-term policy decisions with which to manipulate the economy involve short-term interest rates. Consequently, the Fed can realistically have only one target—inflation. If the Fed perceives that prevailing forces will increase inflation, it will attempt to slow the economy by raising short-term interest rates. This is based on the assumption that increases in the cost of borrowing money are likely to dampen both personal and business spending. Conversely, if the Fed perceives the economy has slowed too much, it will attempt to stimulate growth by lowering short-term interest rates. The assumption is that lower costs for borrowing will likely stimulate spending.

In maintaining this balancing act, the Fed walks a fine line. If it doesn’t tighten the reins soon enough (by raising interest rates), it runs the risk of uncontrolled inflation. If it fails to loosen soon enough (by lowering interest rates), it can plunge the economy into recession. Indeed, one might argue that the primary goal of the Fed is to keep inflation low enough so that it is not a factor in business decisions.

Up, Down, or Sideways?

By looking at your own spending and debt burden (and that of your friends, relatives, and business associates), you may gain some insight into the short-term future of the economy. While by no means the whole story, this small segment is indicative of a significant chapter since it is the one over which individuals can exercise the greatest control. When combined with a little judicious Fed watching (e.g., several interest rate moves in the same direction may be an indication that the Fed is on a mission), you may have a fairly good basis for making sound financial decisions.


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