RESPONSE TO THE REVIEW OF TREASURY’S MACROECONOMIC FORECASTING CAPABILITIES
Background
In late 2015 the Secretary to the Treasury requested a review be undertaken of Treasury’s
macroeconomic forecasting methodology. A copy of the Review is at Attachment A. The review was undertaken to assess the processes and tools that Treasury relies upon and to examine whether Treasury’s approach is in line with the best practice used in fiscal agencies and central banks in other advanced economies.
Treasury forecasts the economy for the purpose of preparing the Commonwealth budget and the Mid-Year Economic and Fiscal Outlook. That requires us to prepare ‘point estimates’ of 120
parameters that are then used to prepare estimates of expenses and revenue. We are also required to provide these parameters for the four years of the forward estimates that are reported in the budget and the mid-year update.
Treasury also provides an analysis of the error bands around the key forecast variables and an analysis of how sensitive the key budget variables are to changes in some key assumptions. This analysis is as important to an understanding of the possible future path of the Australian economy and the budget as the more detailed point estimates. That said, it is the detailed point estimates that receive most interest and against which our forecasting performance is judged.
The Review is the latest step in a process of continuous improvement in Treasury’s economic
forecasting capability. It follows reviews undertaken in 2002, 2005 and 2012 and initiatives such as a new approach to estimating medium-term projections that was introduced in the 2014-15 Budget.1 While the earlier reviews were of Treasury’s forecast performance - how well the forecasts tracked economic outcomes - the focus of this review was Treasury’s methodology.
The Review was undertaken by Warren Tease who was recruited to Treasury in 2015 following a career in the finance sector and at the Reserve Bank of Australia. This combined the benefits of an
‘outsider’ who had no pre-conceived views, with the benefits of an ‘insider’ who could engage with all aspects of the process. In undertaking the review, Mr Tease sat in on all formal and informal meetings and observed the participation of junior and senior officers in the update to the forecasts that was undertaken following the release of the June quarter national accounts.
Treasury accepts all the recommendations made in the Review. The effect of implementing the recommendations will be to broaden the source of information and insight into the economic trends that shape the forecasts.
1 Speech available at http://www.treasury.gov.au/PublicationsAndMedia/Speeches/2015/The-Macroeconomic- Context
Working Paper available at http://treasury.gov.au/PublicationsAndMedia/Publications/2014/Tsy-Medium- Term-Projection
Recommendations
The recommendations of the Review can be categorised into three broad groupings: to broaden the analytical inputs and contributions of senior staff; to address the role of judgment, biases and culture; and the development of Treasury analysts who develop the forecasts. The full set of recommendations is at pages 13 to 17 of the Review at Attachment A.
Broaden analytical inputs and the contribution of senior staff
This set of recommendations aims to broaden the range of inputs on which Treasury relies in order to assist in identifying trends and linkages that may not be picked up in any single approach.
Treasury will embed an economy-wide model early in the process for the 2016-17 and subsequent budgets.
The 2012 Review of Treasury Economic Forecasts also recommended that Treasury rely more heavily on an economy-wide model. In response to that recommendation Treasury purchased an existing economy-wide model and began to develop the in-house expertise necessary to run the model.
We will now employ the model in the early stages of the development of the forecasts to better take account of the interlinkages between forecast variables.
We will also develop ‘in-house’ a wider range of alternative techniques to forecast the economy and convene an external panel of experts to provide advice on those alternatives.
Analysis of Risks
To ensure that we are aware of the range of views on the outlook we are engaging more broadly within Treasury at the start of the forecasting round. We will also expand our liaison with other economic forecasters. The establishment of the Sydney Office, and the soon to be opened Melbourne Office, facilitates more regular engagement with private sector economists.
In the 2015-16 Budget, a new Statement was introduced into Budget Paper No.1 that focusses on the risks to the economic outlook and to the budget aggregates. It included a range of sensitivity analyses across the economic forecasts and the forecasts of expenses and revenue. We will continue to assess that analysis and look at ways to elucidate the risks around the forecasts.
Staffing
Staff movement within Treasury requires a continuing focus on developing analysts’ technical skills.
We have a number of initiatives in place to offer in-house and external training and development opportunities to build the skills that we will need to implement the recommendations of the Review.
Additionally, we have appointed a senior officer whose key role is to build capability through providing technical coaching and mentoring.
Macroeconomic Group The Treasury
8 March 2016