Monday, June 04, 2007

Forecasting decisions versus events 

I said something on the air Saturday that, based on a couple of phone calls after the show, appears to require some explanation. What I said was that there are two entirely different types of forecasting one is discussing in this budget inflation debate.

One type of forecasting is forecasting of an event. The revenues generated by the tax code are the result of an event -- what happens in the economy -- multiplied by a vector of tax rates that collect revenue based on a matrix of flows of income and stocks of wealth or assets in the hands of economic agents. The tax rates are constant; the movement in tax bases comes from the Global Insights forecast (as I mentioned earlier). Insert the numbers from that economic forecast in the matrix, plug and chug, and there you are, a revenue forecast.

What I said on the air was that you can't forecast decisions. That's not right exactly; there's a very good example of decision-forecasting in the Taylor Rule, which is a forecast of the Federal Funds rate target set by the Federal Reserve as the basis of its monetary policy. It is a description of how monetary policy was being set under the leadership of Chairman Greenspan. (Does it describe Chairman Bernanke? Look at the graph and decide for yourself. The Taylor Rule, properly understood, is not a mechanism that predicts an economic event but a heuristic used to try to understand how the FOMC is deciding policy at that point in time. The rule is not independent of the committee whose behavior it is forecasting.

Legislatures and executives do not automatically adjust spending to inflation. The budget forecast provided, as noted by the House Fiscal Analysis Department, is the budget's structural balance, i.e., "how much more is being collected than spent before any tax or spending decisions are made." (Emphasis added.) They may do so as an element of policy; the budget forecast provides information on what additional spending would occur if all non-indexed items were to be raised by inflation as measured by CPI. But is it appropriate for an arm of the executive branch to forecast a policy decision of the legislative branch? I think it is not.

There is, by the way, a very simple solution. The Federal government has both an Office of Management and Budget (reporting to the executive branch) and a Congressional Budget Office. If the DFL wants a forecasting arm that reports budget figures the way they would like to read them, have the Senate and House Fiscal Analysis Department provide you that information. What the DFL is doing instead is censoring the information the Finance Department can provide, but not allowing it to report spending without inflation. This is a bad policy.

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