Bank of Estonia: 2020 economic forecast misread due to false assumptions

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Bank of Estonia (Eesti Pank) economist Kaspar Oja. Source: Bank of Estonia

Economic forecasts made early on in the coronavirus pandemic turned out to have been overly pessimistic for 2020 and, to an extent, 2021, the Bank of Estonia (Eesti Pank) says, and were based on some unfounded assumptions.

While the early stages of the pandemic in spring 2020 may have represented uncharted waters, lessons can be drawn for forecasts going forward, even in the case of returning restrictions and in relation to the international coronavirus picture, as well as the domestic one.

At the same time, Estonia's relatively mild restrictions compared with many other EU and European nations - including its nearest neighbors such as Latvia and Finland - has likely had a positive effect on economic recovery and growth, while the arrival of vaccine doses at the end of 2020, gathering in pace in the spring, has done the same.

Bank of Estonia economist Kaspar Oja gives as one example of early pessimism the June 2020 forecast of a 10-percent downturn, which in actuality turned out to stand at 3 percent by the time the year finished.

Bank: External and domestic factors both misread

Oja noted on the Bank of Estonia's blog that: "Approximately half of this forecast error can be explained by a change in external assumptions, meaning the crisis-time forecasts for the outside world overreacted to the downturn."

"Broadly speaking, the analysis of forecast errors has two results. First, it confirmed that a large part of last year's economic downturn was related to factors outside Estonia. Second, the analysis showed that most of the error in the Bank of Estonia's economic forecast made a year ago was also due to overly pessimistic assumptions about the external environment," he continued.

"As of now, we know that Estonian export markets did much better than assumed they would last spring. However, we cannot attribute the entire forecasting error to external environmental factors; the impact of the restrictions on the economy was also smaller than feared," Oja continued.

Some growth areas unexpected

The bank has identified two categories of macro-level errors in forecasting: Those arising from inaccurate assumptions internationally, and those relating to Estonia specifically, BNS reports.

"The remaining forecast error can be attributed to a faster-than-expected recovery from domestic restrictions, but also to unexpectedly rapid growth in some sectors," Oja went on, referring to category two above.

He said: "By the time of the forecast made in September 2020, it was clear that the Estonian economy had fared much better than we thought it would do in the spring".

Methodologies agreed at EU-level

"In September, foreign markets were expected to decline less than we feared in the spring. As a result, we have also revised Estonia's forecast in a more optimistic way."

Further examples of external assumptions, the first category above, include, Oja said: "Demand on export markets, price indexes of foreign competitors, short-term interest rates and commodity prices".

"We do not forecast these factors ourselves, but use the assumptions made on them on the basis of the methodology agreed by the Eurosystem - the European Central Bank (ECB) and the central banks of the euro area," Oja added. "Such assumptions are based on the forecasts of other analysis institutions and the expectations of the financial markets."

Forecasts revised

Demarcating the dividing line between domestic and international factors went as follows, Oja wrote: "In order to understand how much of Estonia's GDP change during the coronavirus crisis was due to external factors and how much domestic, we compared the central bank's economic forecasts made since the beginning of 2020 with the pre-crisis forecast prepared at the end of 2019."

Most of the deterioration of economic growth in 2020 compared with what was expected in December 2019's forecast has been explained by the change in external assumptions in all subsequent forecasts, he said.

"The most recent external assumptions already reflect actual data for 2020. Thus, we can say that the deteriorating situation in foreign markets during the coronavirus crisis slowed down economic growth by approximately five percentage points last year compared to the forecast at the end of 2019," Oja went on.

Arrival of the vaccination program

"However, in the forecast published in December 2020, we already assumed that vaccination would boost economic recovery and therefore GDP should grow faster in mid-2021 than expected in September. The fall months of 2020 also showed that Estonia's approach has been different from other EU countries, and milder restrictions also supported economic development."

As to rectifying forecasting in future, Oja noted that: "When making forecasts, we can react more flexibly and with a shorter delay when taking these factors into account."

Fiscal policy, expert assessments about the recovery from restrictions and the revision and adjustment of model input data, such as GDP are all relevant factors.

Restrictions imposed also had their effect, Oja noted, adding that state support schemes had helped mitigate the worst of the fallout from the crisis, in the bank's view.

Restrictions may come back

Estonia is not out of the woods altogether with regard to restrictions – both its own and those of other countries, particularly neighboring ones – Oja noted, and more restrictions are expected for this autumn, which will also be taken into account.

Another factor in Estonia's growth was the effect of the liberalization of the Estonian pension system which has allowed many pension holders to cash out. This effect will continue into 2022, he said.

Still in 2021, ultimately, Oja said that: "According to the latest forecast made by the Bank of Estonia in June, economic growth in 2021 will be faster than we expected in March."

"This is due to the faster recovery of foreign markets as well as domestic factors. For example, the forecast reflects relatively fast economic growth at the beginning of 2021, which exceeded expectations despite the restrictions."

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Editor: Andrew Whyte

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