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Ottawa, Canada

August 30, 2010

www.parl.gc.ca/pbo-dpb

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

(PBO) to provide independent analysis to the Senate and House of Commons

on the state of the nations finances, government estimates and trends in the

national economy.

their understanding of the state of the nations finances and trends in the

national economy.

To better understand Canadas economic performance PBO calculates output and

income gaps based on its own estimates potential gross domestic product (GDP)

and potential gross domestic income (GDI).

To better understand changes in the Governments budgetary balance and its

underlying fiscal position, PBO provides estimates of the structural and cyclical

budgetary balances.

To better understand the sustainability of the Governments finances, PBO provides

long-term economic and fiscal projections as well as estimates of the fiscal gap (i.e.,

the amount of measures required to achieve fiscal sustainability).

To better understand the uncertainty and risks surrounding the economic outlook

and the fiscal implications, PBO is providing fan charts for real GDP growth forecasts

and the Governments budgetary balance.

This note describes the procedure used to construct a fan chart for real GDP

growth forecasts. Fan charts can be used to illustrate the uncertainty

surrounding forecasts thereby enhancing discussions about risks and helping

policymakers to gauge the likelihood of possible economic scenarios.

________________________________________________________________________________________

* The author thanks Mostafa Askari, Russell Barnett, Jeff Danforth, Kevin Page and Stephen Tapp

for their helpful comments and technical assistance. The author would also like to thank Prakash

Kannan for providing his IMF fan chart spreadsheet. Any errors or omissions are the responsibility

of the author.

i

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

Key Points

Economic forecasts presented in the Governments budgets and fiscal updates provide a single or

point forecast, which represents only one possible future outcome. Different economic outcomes

with varying degrees of probability are of course possible. Although it is not possible to know, with

certainty, the distribution of these future outcomes, it is nonetheless useful to illustrate the

uncertainty surrounding a baseline economic forecast to enhance discussion about risks to the

economic outlook and to help policymakers gauge the likelihood of possible economic scenarios.

This note details an approach for constructing a fan chart for real GDP growth forecasts. This

approach is based on the methodology described in Elekdag and Kannan (2009), which has been used

to construct the IMFs world GDP growth fan chart. To illustrate the application of this methodology

to Canadian forecasts, PBO uses the forecasts of real GDP growth in 2010 and 2011 presented in

Budget 2010. These forecasts are assumed to be the central forecasts around which a probability

distribution of possible outcomes is overlaid, based on the historical forecast accuracy of the

Department of Finances survey of private sector forecasters. Further, using private sector forecasts

made at the time of Budget 2010, this distribution is augmented to reflect the balance of risks for key

external factors, which include U.S. economic and financial conditions as well as commodity prices.

At the time of Budget 2010, private sector forecasters anticipated real GDP growth of 2.6 per cent in

2010 and 3.2 per cent in 2011. Distributions of private sector forecasts of U.S. real GDP growth, U.S.

interest rates and oil prices suggested downside risk to the budget forecast of Canadian real GDP

growth. Based on historical forecast errors and downside risk embedded in private sector forecasts

at the time of the budget, PBO estimates that there is a 50 per cent chance (or probability) that real

GDP growth in 2010 would fall between 1.0 and 3.0 per cent (i.e., a 50 per cent confidence interval).

For 2011, there is a 50 per cent chance that real GDP growth would fall between 1.2 and 3.9 per cent.

8 8

90 per cent confidence

50 per cent confidence

2 2

0 0

-2 -2

-4 -4

2006 2007 2008 2009 2010 2011

ii

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

Moreover, based on the probability distribution underlying the confidence intervals shown in the fan

chart, the chance that real GDP growth in 2010 and 2011 would be lower than forecast in Budget

2010 is approximately 64 and 62 per cent, respectively. The recent (June) Department of Finance

survey of private sector forecasters, however, indicates real GDP growth of 3.5 and 2.9 per cent,

respectively, in 2010 and 2011. In terms of the above confidence intervals, the recent forecast for

2010 would sit just above the upper bound of the 70 per cent confidence interval and for 2011, the

recent forecast would fall roughly in the middle of the 50 per cent confidence interval.

The fiscal implications of the distribution of possible outcomes for real GDP growth can be illustrated

using the fiscal sensitivity published in Budget 2010. Given the Governments forecasted budgetary

deficits of $49.2 billion and $27.6 billion in 2010-11 and 2011-12 respectively, the confidence

intervals for real GDP growth and Budget 2010 fiscal sensitivity imply that there is a 50 per cent

chance that the budgetary deficit would be between $47.9 and $53.9 billion in 2010-11. For 2011-12,

the confidence intervals imply that there is a 50 per cent chance that the budgetary deficit would be

between $24.0 and $39.2 billion. The probability distribution of real GDP growth forecasts also

implies that there is a 64 and 62 per cent chance, respectively, that the budgetary deficit in 2010-11

and 2011-12 would be higher than forecast in Budget 2010.

Outcomes with Downside Risk ($ billions)*

20 20

10 10

0 0

-10 -10

-20 -20

Budget 2010 forecast

-30 -30

90 per cent confidence

50 per cent confidence

-50 -50

-60 -60

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

* This fan chart should not be interpreted as representing the distribution of

possible outcomes for the budgetary balance as it does not reflect sources of

uncertainty related to other economic forecasts (e.g., for inflation and interest

rates) and to the translation of economic forecasts into fiscal forecasts.

iii

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

public sector net borrowing to:

Forecasts from the Department of Finances survey help to promote transparency and illustrate the

of private sector forecasters form the basis for the uncertainty that the Government faces in

economic assumptions that underlie the fiscal planning fiscal policy, and in meeting any

projections presented in the Governments numerical target. Explicit recognition of

budgets and fiscal updates. While the average of uncertainty can help commentators assess the

the surveys forecasts is used as the economic Governments fiscal plans.

baseline for fiscal planning, it is nonetheless a

single or point forecast around which different The following details an approach for constructing

outcomes with varying degrees of probability a fan chart for real GDP growth forecasts based on

are possible. It is not possible, however, to know the Department of Finance Canadas survey of

with certainty the distribution of possible future private sector forecasters. The approach follows

economic outcomes. Nonetheless, it is useful to the procedure described in Elekdag and Kannan

illustrate the uncertainty surrounding the baseline (2009) on which the IMF fan chart is based. The

economic forecast to enhance discussion about focus of this note is cast on the outlook for real

risks to the economic outlook and to help GDP growth, however, this approach could be

policymakers gauge the likelihood of possible extended to other indicators.

economic scenarios.

2. The Distribution of Possible Outcomes and

Indeed, since 1996 the Bank of England has the Balance of Risks

published its inflation forecast in the form of a

probability distribution or fan chart that provides Britton et al. (1998) discuss the choice of the

confidence levels associated with its projection. distribution of possible outcomes used in

Britton et al. (1998) note that one of the Bank of constructing the Bank of Englands inflation fan

Englands objectives for introducing the fan chart chart. Extending this discussion to real GDP

was that it had wanted to focus attention on the growth, one might expect future real GDP growth

whole of the forecast distribution to promote to be distributed (roughly) symmetrically around

discussion of the risks to the economic outlook, the most probable or central value, with values

and thus contribute to a wider debate about closer to the centre more likely to be realized than

economic policy. those further away, suggesting the familiar normal

bell-shaped distribution.1

The International Monetary Fund (IMF) has also

published (since 2006) its world GDP growth The dispersion of possible outcomes for future real

forecast in the form of a fan chart. IMF (2009) GDP growth (measured by the standard deviation)

notes that the fan chart serves primarily as a reflects the degree of uncertainty. That is, a wide

visual communications device and addresses the dispersion and large standard deviation indicates a

questions: high degree of uncertainty. The symmetry of the

What is the baseline forecast for the current

distribution of possible outcomes indicates that

and future years? outcomes greater than or less than the central

value are equally likely. It could be the case,

What level of uncertainty surrounds the

forecast? however, that the distribution of possible

outcomes is asymmetric, or skewed, and the

Where does the balance of risks lie?

expected outcome (the mean forecast) differs from

More recently, the United Kingdoms Office for

Budget Responsibility (OBR) has published fan

1

This framework assumes that the distribution of possible outcomes

is unimodal.

1

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

the single most likely outcome (the mode This distribution underlies the construction of the

forecast). Bank of Englands inflation fan charts, the IMFs

world GDP growth fan chart and the OBR fan charts

Figure 1 provides an illustration of symmetric and of real GDP growth and public sector net

skewed distributions with the same central borrowing.

forecast (i.e., the same mode). In the case of the

symmetric distribution, the single most likely Following the IMF, constructing the fan chart for

outcome (the mode) is equal to the expected Canadian real GDP growth requires an estimate of

outcome (the mean) and there is an equal chance the uncertainty surrounding the central forecast

that outcomes could exceed or fall short of the and an estimate of the degree of skewness. For

central forecast. This would suggest that the risks the purposes of this note, PBO takes the private

to the central forecast are balanced. In the case of sector forecast of real GDP growth presented in

a (negatively) skewed distribution the expected Budget 2010 as the central forecast and uses the

outcome is less than the central forecast, which private sector surveys historical forecast errors to

suggests that the balance of risks to the central determine the degree of uncertainty surrounding

forecast is to the downside. Thus the skewness this forecast. Using the approach developed by

value (positive or negative) of the distribution of Elekdag and Krannan (2009), the skewness value of

possible outcomes reflects the balance of risks the distribution of possible outcomes is based on

(upside or downside) to the central forecast. the skewness of private sector forecasts of proxies

for external economic and financial conditions as

Figure 1 well as commodity prices.

Symmetric and Skewed Distributions

3. Uncertainty Surrounding the Private

(Probability distribution)

0.50 0.50

Sector Forecast of Real GDP Growth

Single most likely

Expected outcome with outcome (mode) The forecast of real GDP growth presented in

0.40 skewed distribution 0.40

(mean) Budget 2010 represents the average of the

individual forecasts in the Department of Finances

0.30 0.30 survey of private sector forecasters. Although the

Symmetric

Skewed distribution

(mean = mode) individual forecasts in the survey provide a

(left skew)

distribution of possible outcomes, PBO believes

0.20 0.20

that the dispersion of these forecasts is not a

robust measure of the uncertainty surrounding the

0.10 0.10 surveys average forecast.3 PBO (2010) noted that

research examining the dispersion of private sector

0.00 0.00

Source: Office of the Parliamentary Budget Officer. deviations differ determines the skewness of the overall distribution.

Note: The area under each distribution is equal to 1.0. The skewed Elekdag and Kannan (2009) provide a summary of the key features of

distribution is constructed using a two-piece normal this distribution, based primarily on John (1982).

3

distribution. For example, there may be a tendency for herding among

forecasters such that no forecaster wishes to deviate too far from the

consensus forecast, leading to forecast clustering. As a result, the

The two-piece normal distribution provides a degree of uncertainty surrounding the average forecast may be

understated. The 2005 research report on the Department of

convenient framework to illustrate the uncertainty Finances forecasting processes and performance conducted by the

surrounding a forecast and the balance of risks.2 Policy and Economic Analysis Program (PEAP) and Centre

Interuniversitaire de Recherche en Analyse des Organisations

(CIRANO) speculated that, based on a sub-sample of forecasters, the

2

This distribution can be thought of as the combination of two halves domination (with respect to forecast accuracy) of the average private

of two separate normal distributions with the same mode but with sector forecast was a signal that the forecasters in truth look very

different standard deviations. The degree to which the standard much alike and that further investigation of this issue was warranted.

2

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

forecasts as a measure of uncertainty for Canada Under the assumption that current forecasts are

and other countries is not conclusive. not biased7 (i.e., there is no tendency to over- or

under-predict) and based on the normal

Therefore PBO, following Elekdag and Kannan distribution, this means that there is a 68 per cent

(2009) and the OBR, uses the historical forecast chance or level of confidence that the one-

errors of the Department of Finances surveys of year (two-year) ahead forecast error for real GDP

private sector forecasters to provide an estimate of growth will lie within plus or minus one standard

the standard deviation of the distribution of deviation, or between -1.5 and +1.5 (-2.0 and +2.0)

possible outcomes for future real GDP growth. As percentage points.8 Plus or minus two standard

noted by the OBR, this approach has its limitations deviations (i.e., 3 percentage points and 4

in that the past forecast performance is only an percentage points, respectively, for one- and two-

imperfect guide to the future nevertheless, it does year ahead forecasts) would result in a 95 per cent

provide a clear, transparent and objective method level of confidence.9

for quantifying the degree of uncertainty.4

Using the private sector forecast of real GDP

Forecast errors for one- and two-year ahead growth in 2010 and 2011 from Budget 201010 (2.6

forecasts of real GDP growth are calculated for the and 3.2 per cent respectively) as the central

period 1994-2009 using the Department of forecast (and under the assumption that the risks

Finances surveys from December, which are to the forecast are balanced), the distribution of

typically used for budget projections.5 Using the possible outcomes can be generated using the

current vintage of real GDP growth as the actual density function of the normal distribution and the

against which the forecast is compared, PBO above standard deviations. Figure 2 presents

calculates the standard deviation to be 1.5 and 2.0 distributions of real GDP growth in 2010 and 2011

percentage points for the one- and two-year ahead respectively based on historical forecast errors of

forecast errors, respectively.6 The standard Finance Canadas private sector survey.

deviation is larger for the two-year ahead forecast

error, which suggests that the uncertainty Figure 2 indicates that assuming balanced risks,

surrounding the forecast in year two is greater there is a 50 per cent chance that real GDP growth

than the uncertainty in year one. in 2010 would be between 1.6 and 3.6 per cent.

The increased uncertainty surrounding two-year

ahead forecasts implies that the 50 per cent

confidence interval for real GDP growth in 2011

would be between 1.9 and 4.5 per cent.

4

Robbins et al. (2007) use the historical forecast errors of the

Department of Finance survey of private sector forecasters as a check

of the reasonableness of the dispersion of their stochastic model-

based distributions. 7

5 Statistical tests indicate that the hypothesis that the real GDP growth

Forecast errors for the period 1994-2006 are based on Robbins et al.

forecast errors are zero on average cannot be rejected. These test

(2007). For 2007 and 2008, respectively, forecast errors are calculated

results, however, should be treated with some caution given the small

using the private sector forecasts presented in Budget 2007 (March

sample size.

2007 survey) and Budget 2008 (December 2007 survey updated in 8

January 2008). The forecast error for 2009 is calculated from the Statistical tests indicate that the hypothesis that the distribution of

December 2008 survey of private sector forecasters (see real GDP growth forecast errors is normal cannot be rejected. These

http://www.fin.gc.ca/n08/data/08-106-eng.asp). On June 12 2010, test results, however, should be treated with some caution given the

PBO requested from Finance Canada the summaries of its survey of small sample size.

9

private sector forecasters since 1994 in order to expand and complete Elekdag and Kannan (2009) refer to the uncertainty based on

its analysis (see http://www2.parl.gc.ca/sites/pbo- historical forecast errors as a baseline measure of uncertainty.

dpb/documents/Info_Request_030_R.pdf). To date, this information Further, they augment this uncertainty to take into consideration the

has not been provided to PBO. current assessment of forecast uncertainty relative to its historical

6 level.

The standard deviation of forecast errors based on Statistics

10

Canadas initial estimates of real GDP growth is slightly smaller at 1.3 The average private sector forecast of real GDP growth presented in

and 1.8 percentage points, respectively, for one- and two-year ahead Budget 2010 is based on the December 2009 Department of Finance

forecasts. survey of private sector forecasters.

3

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

Figure 2 Figure 3

Real GDP Growth Outcomes in 2010 and 2011 Real GDP Growth Fan Chart (balanced risks)

(Probability distribution) (Per cent)

0.30 0.30 8 8

90 per cent confidence

50 per cent confidence

0.15 0.15 2 2

Budget 2010:

2.6 per cent

0.10 0.10 0 0

0.05 0.05 -2 -2

0.00 0.00 -4 -4

-4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 2006 2007 2008 2009 2010 2011

Real GDP growth in 2010 (%)

Sources: Office of the Parliamentary Budget Officer; Statistics Canada;

0.30 0.30 Finance Canada.

Note: Real GDP growth over 2006-2009 is Statistics Canadas

0.25 0.25 estimate as of May 31, 2010.

0.20 0.20

0.15 0.15

4. Determining the Balance of Risks

Budget 2010:

0.10

3.2 per cent

0.10 Typically, determining where the balance of risks to

a forecast lies is based on a forecasters subjective

0.05 0.05 judgement. Elekdag and Kannan (2009), however,

develop a procedure to gauge the balance of risks

0.00 0.00 based on a more objective approach. Essentially,

-4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 the authors employ survey- and market-based

Real GDP growth in 2011 (%)

data, which they argue are inherently forward-

Source: Office of the Parliamentary Budget Officer.

looking and could therefore inform policymakers

on the evolution of risks as perceived by markets,

These probability distributions can be used to to determine where the balance of risks lies.

construct intervals for any level of confidence and

provide the cross-sections of the values used in That said, Elekdag and Kannan (2009) suggest that

constructing the fan chart of real GDP growth a layer of judgement could and perhaps should

forecasts. be added to incorporate other risk factors that

are not easily quantified. Indeed, the use of

Figure 3 presents PBOs fan chart of real GDP survey-based forecasts to inform ones judgement

growth forecasts, based on Budget 2010, for 50, 70 on the balance of risks should be regarded as a first

and 90 per cent confidence intervals. These step toward a more objective risk assessment.

intervals are computed under the assumption that Further work on this issue is warranted.

the risks to the Budget 2010 forecast of real GDP

growth are balanced (i.e., the probability In the case of survey-based data, this procedure

distributions are symmetric about the budget involves first identifying relevant quantifiable risk

forecast).

4

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

factors.11 The next step involves determining the Distributions of private sector forecasts of the

skewness (if any) among the individual forecasts of identified risk factors in 2010 and 2011 (made at

each risk factor. Lastly, the skewness values of the the time of Budget 2010) appear to be negatively

individual risk factors are aggregated to form an skewed.14 Based on Elekdag and Kannans

overall measure of skewness, which is then used procedure, this would suggest that the balance of

based on the two-piece normal distribution to risks to Canadian real GDP growth in 2010 and

augment the distribution of possible outcomes 2011 from U.S. growth, U.S. financial conditions

generated from the historical forecast errors. The and oil prices is to the downside.

weights used to aggregate the individual risk

factors are based on estimated sensitivities of the Figure 4

forecasted variable to the risk factors. Balance of Risks to Canadian Real GDP Growth

Associated with Selected External Risk Factors

To illustrate this procedure, PBO identifies a subset

(Coefficient of skewness)

of (external) risk factors to the Budget 2010

0.00 0.00

outlook for real GDP growth in 2010 and 2011 and

uses the skewness observed in distributions of

private sector forecasts of these risk factors made -0.25 -0.25

at the time of Budget 2010.12 The skewness values

of the risk factors are then aggregated using

estimation and model-based sensitivities. -0.50 -0.50

2010

2011

Risk Factors and the Balance of Risks

-0.75 -0.75

developing a forecast of Canadian real GDP growth -1.00 -1.00

given that Canada is a relatively small open U.S. growth U.S. term spread WTI oil price

economy and net exporter of commodities. This

Sources: Office of the Parliamentary Budget Officer; Consensus

illustration therefore focuses on risks related to

Economics.

external economic and financial conditions as well Notes: The coefficient of skewness is calculated based on the mean

as commodity prices. Figure 4 presents the and variance of the distribution of forecasts (see footnote

balance of risks to Canadian real GDP growth 14) and is expressed in units of the underlying variables.

associated with selected external risk factors: U.S. A negative (positive) skewness coefficient indicates that

there is downside (upside) risk to the forecast of Canadian

real GDP growth, U.S. interest rate term spread13 real GDP growth.

and West Texas Intermediate (WTI) oil prices. The term spread is calculated as the U.S. 10-year Treasury

bond yield minus the U.S. 3-month Treasury Bill rate.

11

Alternatively, the skewness of current survey-based forecasts of skewness coefficients for the individual risk factors

real GDP growth itself could be used to determine an overall measure are weighted by their elasticities (i.e., the

of skewness.

12 sensitivity of Canadian real GDP growth to the risk

Individual private sector forecasts of the external risk factors are

taken from January 2010 Consensus Economics surveys to coincide

factor in question). Based on regression and

with the December 2009 Department of Finance survey of private

sector forecasters. These forecasts were used in place of Finance

Canadas since PBO does not have access to the individual private

sector forecasts in the Departments survey. That said, the average

forecasts of U.S. and Canadian real GDP growth in 2010 and 2011 in 14

There are several measures of skewness. The coefficient of

the two surveys are almost identical. skewness shown in Figure 4 is calculated based on the mean and

13

Elekdag and Kannan (2009) proxy financial conditions by the variance of the distribution of forecasts. For additional detail, see

interest rate term spread (i.e., the long-term minus the short-term EViews 6 User Guide I (p. 307). Elekdag and Kannan (2009) use a

interest rate) as well as by the Standard and Poors 500 index. variant of Pearsons skewness coefficient.

5

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

model-based weights15 the overall measure of cent in 2010, and between 1.2 and 3.9 per cent in

skewness is estimated at -0.6 for 2010 and -0.7 for 2011.

2011. This suggests that, based on private sector

forecasts of key external factors made at the time Further, based on the probability distribution

of Budget 2010, the overall balance of external underlying the confidence intervals presented in

risks to the real GDP growth forecast in Budget Figure 5, there is approximately a 64 (62) per cent

2010 is tilted to the downside.16 chance that real GDP growth in 2010 (2011) would

be lower than forecast in Budget 2010.

Adjusting the Distribution of Possible Outcomes for

the Balance of Risks Figure 5

Real GDP Growth Fan Chart (downside balance of

The fan chart shown in Figure 3 can be augmented risks)

to incorporate the downside balance of risks.17

(Per cent)

Following Elekdag and Kannan (2009), the

8 8

symmetric distribution of possible outcomes for

real GDP growth is adjusted such that the 6 Budget 2010 forecast 6

difference between its mean and mode (which is 90 per cent confidence

aggregate skewness value of the risk factors and its 50 per cent confidence

historical forecast errors. This adjustment

0 0

effectively shifts the confidence intervals while the

central forecast remains at its mode the private

-2 -2

sector forecast from Budget 2010. For example, in

the case of balanced risks, there is a 50 per cent -4 -4

chance that the real GDP growth would fall 2006 2007 2008 2009 2010 2011

between 1.6 and 3.6 per cent in 2010, and

Sources: Office of the Parliamentary Budget Officer; Statistics Canada;

between 1.9 and 4.5 per cent in 2011. In the case

Finance Canada.

where the balance of risks is to the downside

Note: Real GDP growth over 2006-2009 are Statistics Canadas

(Figure 5), there is a 50 per cent chance that real estimates as of May 31, 2010.

GDP growth would fall between 1.0 and 3.0 per

15

The June Department of Finance survey of private

Regression results are based on the approach used by Elekdag and

sector forecasters, however, indicates real GDP

Kannan (2009), which involves regressing Canadian real GDP growth

against the risk factor and lagged growth. Model-based estimates are growth of 3.5 and 2.9 per cent, respectively, in

taken from Murchison and Rennison (2006). The weight for U.S. real 2010 and 2011. In terms of the confidence

GDP growth is 0.62; 0.61 for the U.S. term spread; and, 0.20 for oil

prices. These weights, however, should be regarded as preliminary as

intervals shown in Figure 5, the recent forecast for

further work is required to ensure their robustness. 2010 would sit just above the upper bound of the

16

Budget 2010 provides a limited discussion of the risks to the private 70 per cent confidence interval and for 2011, the

sector economic forecast and does not explicitly state the recent forecast would fall roughly in the middle of

Governments judgement as to where the balance of risks lies. This

stands in contrast to the economic risk assessment provided in Budget the 50 per cent confidence interval.

2009 in which the Government judged that downside risks to the

global economic outlook and commodity prices were significant and

prompted the Government to adjust downward the private sector 5. Fiscal Implications of Possible Outcomes

forecast of nominal GDP.

17

for Real GDP Growth

This augmentation uses the two-piece normal distribution.

Calculations required to generate the desired skewness and overall

dispersion of the distribution are based on Elekdag and Kannan (2009). The fiscal implications of the distribution of

The corresponding confidence intervals, however, are computed by possible outcomes for real GDP growth can be

generating the probability density function. This guarantees that the illustrated using the fiscal sensitivity published in

central forecast remains the mode of the distribution.

6

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

the impact on the Governments budgetary Budgetary Balance Implications given Real GDP

balance of a 1 per cent reduction in real GDP over Growth Outcomes with Downside Risk

the forecast horizon: a 1 per cent reduction would

($ billions)

lower the budgetary balance by $3.1 billion in the

20 20

first year and by $3.4 billion in the second year.

10 10

budgetary balance constructed using the

-10 -10

confidence intervals for real GDP growth18 in which

the balance of risks is to the downside (Figure 5) -20 -20

Budget 2010 forecast

and using the fiscal sensitivity provided in Budget -30 -30

90 per cent confidence

2010.19 The central forecast of a $49.2 billion

-40 70 per cent confidence -40

deficit in 2010-11 and a $27.6 billion deficit in

50 per cent confidence

2011-12 is the Governments forecast presented in -50 -50

Budget 2010. -60 -60

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

The confidence intervals for real GDP growth

Sources: Office of the Parliamentary Budget Officer; Budget 2010.

(adjusted for the downside balance of risks) and

the Budget 2010 fiscal sensitivity imply that there

is a 50 per cent chance that the budgetary deficit The probability distribution of real GDP growth

would be between $47.9 and $53.9 billion in 2010- underlying the confidence intervals in Figure 5 also

11; and, between $24.0 and $39.2 billion in 2011- implies that there is a 64 and 62 per cent chance,

12. respectively, that the budgetary deficit in 2010-11

and 2011-12 would be higher than forecast in

Budget 2010.

18

Since these fiscal sensitivities are expressed in terms of (per cent)

deviations of the level of real GDP from its baseline, the distributions

of possible real GDP growth outcomes must be first translated into

real GDP (level) deviations from the central forecast.

19

There are of course additional sources of uncertainty related to

other economic forecasts (e.g., for inflation and interest rates) and to

the translation of economic forecasts into fiscal forecasts (e.g., see

Robbins et al. (2007)). Thus the fan chart presented in Figure 6 should

not be interpreted as representing the distribution of possible

outcomes for the budgetary balance.

7

An Approach for Assessing Uncertainty and the Balance of Risks:

Constructing a Fan Chart for Real GDP Growth Forecasts

References

BRITTON, E., P. FISHER AND J. WHITLEY. 1998. The OFFICE FOR BUDGET RESPONSIBILITY. 2010. Pre-Budget

Inflation Report projections: understanding the forecast June 2010. Available at:

fan chart. Bank of England Quarterly Bulletin. http://budgetresponsibility.independent.gov.uk

Available at: /d/pre_budget_forecast_140610.pdf

http://www.bankofengland.co.uk/publications/

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