Evaluating Medium Term Forecasting Methods and their Implications for EU Output Gap Calculations

This paper sheds light on two specific, but interlinked, questions – firstly, how do the EU's, medium term actual GDP growth rate forecasts compare, in terms of accuracy and biasedness, with those of the EU's Member States, in their annual Stability and Convergence Programme (SCP) updates; and secondly, should medium term forecasts be allowed to influence the short run output gap and structural balance calculations used in the EU’s fiscal surveillance procedures. Regarding the first question, the paper concludes that the EU's medium term forecasts are equally as good, and arguably better, than those of the SCP's both with respect to accuracy and biasedness. Regarding the second question, due to the relatively rapid loss in forecast accuracy as the time horizon lengthens; the paper suggests that using more forecast information should be avoided in the output gap and structural balance calculations. Extending the forecast horizon to be used in the output gap calculations could exacerbate an existing optimistic bias with respect to the supply side health of the EU’s economy, thereby enlarging the risk of procyclicality problems, especially in the upswing phase of cycles, where most of the large fiscal policy errors tend to occur.