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Economic forecasting by trend extrapolation is often employed by both the simple-minded as well as the more complex-minded. It does have a fairly good track record and it is not by chance. An economy is a momentum machine.

The “Mo” in a momentum system boils down to mass times velocity. While the U.S. economy has plenty of mass, it presently has little velocity — as its actual and forecasted real growth rate has slipped to 1.5%.

So the “No Mo” economy nearing stall speed is flashing recession possibilities — but don’t tell the stock market enthusiasts, as they appear to be extrapolating something else.

Surely one would think that in the days when economics was elevated to the status of a science, that we could expect more in the way of methodology and precision for an economic forecast than trend extrapolation which, after all, follows rather than leads.

Indeed, there have been many attempts to make economic forecasting more analytical. This took the form of statistically estimating the relationship among variables of the economy from historical data. The results became the estimated structural equations of the economic system that could be used to imply future values of variables we care about. For a time, it looked like economics had become a hard, as opposed to a soft science.

However, the mathematically complexity and statistically elegance failed to deliver much in the way of future clairvoyance. This is because the models are built on statistically measured past relationships which are subject to sampling error as well as change in how the variables relate to each other. Furthermore, some of economics is behavioral such as how good do we feel about the future and as a result how much will we spend. And after all, how good we feel does change.

But what also changes are the rules of the game such as taxes, regulation or various shocks such as a Hurricane Sandy, or an over-supply of houses and related financial crisis or changes in demographics. As a result of these ever changing realities, forecasts can be thought of as a range of future outcomes with associated probabilities, as shown in the accompanying graph.

It displays the Bank of England’s method of thinking about a forecast. Their inflation forecast from a prior time period is shown as a range from 1 to 4 percent which is likely to be the same today. It is represented by a “fan” of possible inflation rates displayed in red with the darker shades reflecting stronger belief.

But a No Mo economy can turn on a dime, so the forecasting fan can become a wide pink swatch.

Another difficulty of a forecasting model is it builds in the economist’s assumption of how the system works. This is done by imposing constraints on the system’s structure.

As an example, Laurence Meyer, a prominent forecaster and former Fed Governor, has indicated: “The models generally exhibit neutrality, meaning that a higher level of money supply results in proportionate changes in the price level with no effect on equilibrium values of real variables, implying that monetary policy pins down inflation, but does not affect real growth in the long run.”

This attitude imposed on the system did not prove to be correct in that the ultra-expansionary monetary policy of the last six years has not as yet produced anywhere near proportional inflation and has eked out meager real gains.

More importantly, the Fed forecasting model imbeds their current attitude that “private sector expectations of policy constitute a major transmission channel of monetary policy”. That is to say, the Fed’s forecasting model is a reflection of their belief that their optimist forecasts will be self-fulfilling.  It certainly makes the job of forecasting a lot easier to merely state what you want the outcome to be but when unrealized it tarnishes the Fed’s reputation and by association any card-carrying Ph.D. in economics.

So it’s clear that a statically measured theoretical structure especially with preconceived constraints can almost be counted on to produce an embarrassing forecasting. This is especially true at today’s juncture, when the underlying system is subject to major changes rendering forecasting models based on past data almost irrelevant. Furthermore with system change underway, we can’t count on Mo as a forecasting guide because an economy will not likely move down the same path it recently followed.

This is truer today than ever since the underlying structural relationships are in a major state of change. To wit: Consider the long list of mega-issues facing the economy. These tend to fall under the captions of headwinds or tailwinds in today’s discussion.

The tailwinds thrusting the economy forward offer hope that the U.S. can regain manufacturing competitiveness and eliminate its foreign trade deficit within the next few years. The latest reports suggest progress is being made.

This is the result of the combination of cheaper energy and a decline in wages relative to those abroad.  Furthermore energy is becoming an export industry in its own right as energy pipelines are being reversed. That is, pipelines that distributed liquid product from ports to the heartland are now being re-engineered to flow back to the ports for exportation.

At the same time, countering those tailwinds are many significant headwinds. The U.S. regulatory environment is important especially as it relates to financial lending. The sector is in the midst of a great “liquidity trap,” in which $1.8 trillion of excess cash reserves sit idle on the balance sheets of commercial banks, as compared to the post-WWII norm of zero.

But this headwind could be turned into a tailwind if banks recapitalize sufficiently and find willing borrowers and cracks in the regulatory restraints to lending as they are motivated to do.

Then there is the proposed dismantling of mortgage subsidies via Fanny and Freddie. The loss of these government financial guarantees will trickle down to the value of houses and consumer wealth and put a dent into institutional portfolios of mortgage products.

And there is the retreat of both fiscal and monetary policy, via upcoming debt ceiling constraints and the Fed is clearly mulling over when and how to disengage from its epic Quantitative Ease 3.

To muddle the monetary picture further, nearly a third of the members of the Federal Open Market Committee, are seeking to return to other ventures or adventures as they don’t care to be around when QE3 winds down. So no one knows the Chairman or the balance of the succeeding Fed Governors and Fed Bank Presidents who will make the monetary decision.

If that agenda of tailwinds and headwinds is not enough to widen the fan of possible outcomes, there is still the issue of Obamacare costs inducing a 29 hour maximum work week to avoid the Obama care tax which is likely to have an adverse effect on productivity.

And how can we forget population growth (or the lack thereof) and its adverse effects on economic growth (which will be the subject of an upcoming blog), as well as sovereign default issues still present in the Euro zone?

Then there is the issue of the vulnerability of very high corporate profit margins induced by declining real wages. If we are indeed making progress on unemployment, wages likely will drift upwards and the corporate profit margin downward, with stock P/E’s rationally to follow.

All in all, do you care to stick your neck out and forecast how all that will come together and on what schedule? Economic forecasting in this environment has become the economist’s equivalent of Russian Roulette. If I were a Fed Governor, I would also be looking for something else to do, as they will be held responsible for the ill headwinds from whatever source.

But the No Mo forecast in this environment shaking with significant tremors of change is not so much simpleminded but an attempt to gracefully duck the Russian Roulette forecast.

In a similar situation just after the end of World War II, lore has it that Harry Truman’s economists often advised him that “on one hand this, and on the other hand that.” Truman eventually heard enough and asked for a “one-armed economist.”

Narrowing the possibilities with a one-armed economist worked for a decisive guy like Truman, but nonetheless, forecasting is still a game of Russian Roulette in these circumstances. Whether the outcome is the No Mo or the Mighty Mo economy, buckle your seatbelt and draw a wide pink fan on anything you forecast.  This can’t be a source of comfort to equity investors.

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