Fan charts around GDP projections based on probit models of downturn risk

This paper describes a method for parameterising fan charts around GDP growth forecasts of the major OECD economies as well as the aggregate OECD. The degree of uncertainty – reflecting the overall spread of the fan chart – is based on past forecast errors, but the skew – reflecting whether risks are tilted to the downside – is derived from a probit model-based assessment of the probability of a future downturn. This approach is applied to each of the G7 countries separately, with combinations of variables found to be useful in predicting future downturns at different horizons up to 8 quarters: at short horizons of 2-4 quarters, a flattening or inverted yield curve slope, recent sharp falls in house prices, share prices or credit at longer horizons of 6-8 quarters, sustained strong growth in house prices, share prices and credit and at all horizons, a tight labour market and rapid growth in OECD-wide (or in some cases euro-wide) house prices, share prices or credit. The in-sample fit of the probit models appears reasonably good for all G7 countries. The predicted probabilities from the probit models provide a graduated assessment of downturn risk, which is reflected in the degree of skew in the fan chart. Fan charts computed on an out-of-sample basis around pre-crisis OECD forecasts published in June 2008 encompass the extreme outturns associated with the Global Financial Crisis for five of the G7 countries. A weakness of the approach is that, although it predicts a clear majority of past downturns, it will not predict atypical downturns. For example, in the current conjuncture, it is unlikely that current concerns about risks associated with Brexit, an escalation of trade tensions or spillovers from emerging markets would be picked up by the models. At the same time, a severe downturn triggered by such atypical events might be more severe if more typical risk factors are also high.