A Multiple-Equations Approach to Long-Term Forecasting
Short-term forecasting is not the only important element of decision making. Several important decisions consider the longer-term economic outlook.1 For instance, a firm's budget, investment, and employment decisions often incorporate the economic outlook for the next five to seven years. Long-term forecasting of key economic and financial variables, therefore, plays a crucial role in public and private sector decision making. This chapter presents procedures useful to develop models for long-term economic and business forecasting, which differ in several ways from the steps of short-run forecasting.2
When building forecasting models for a longer time period, an analyst should keep a few important points in mind. First, the chances of significant changes in the economic environment are very high. Forecasting the value of the Standard & Poor's (S&P) 500 index a few years out is not easy because there is a high probability of significant changes in the model for equity returns. In January 2008, for example, the U.S. economy was in recession and the S&P 500 index was in bearish territory. If an analyst was trying to make a forecast for the S&P 500 index two years ahead, he or she would struggle with the assumptions. If the recession ended in 2008 and was followed by a strong recovery, the S&P 500 index would have quickly turned bullish. However, that was not the case.3 So longer-term forecasting is associated with higher ...