Do Fed Forecast Errors Matter?*
| Published date | 01 June 2021 |
| Author | Pao‐Lin Tien,Tara M. Sinclair,Edward N. Gamber |
| Date | 01 June 2021 |
| DOI | http://doi.org/10.1111/obes.12415 |
Do Fed Forecast Errors Matter?*
PAO-LIN TIEN,†TARA M. SINCLAIR‡and
EDWARD N. GAMBER§
†The George Washington University, Washington, DC, USA (e-mail: ptien@gwu.edu)
‡The George Washington University, Washington, DC, USA (e-mail: tsinc@gwu.edu)
§Congressional Budget Office, Washington, DC, USA (e-mail: Edward.Gamber@cbo.gov)
Abstract
In order to make forward-looking policy decisions, the Fed relies on imperfect
forecasts of future macroeconomic conditions. If the Fed’s forecasts are rational, then
the difference between the actual outcome and the Fed’s forecast is exogenous to the
information set of the Fed at the time the forecast was produced. We investigate
the effect of the Fed’s forecast errors on output and price movements under the
assumption that the Fed intends to implement policy through a forward-looking Taylor
rule with perfect foresight. Our results suggest that although the mean absolute
magnitude of the Fed’s forecast errors is large, the impact on the macroeconomy is
reassuringly small, although the impact is larger when we take into consideration the
Fed’s inability to forecast recessions.
I. Introduction
This paper presents an approach for measuring the potential economic impact of the
forecast errors made by the Federal Reserve (Fed). There has been considerable debate
about the impact of monetary policy generally on the economy. There has been
parallel research on the quality of the Federal Reserve’s forecasts, but little is known
JEL Classification numbers:E32, E31, E52, E58.
*The views and analysis expressed in this paper are the authors’and should not be interpreted as those of the
Congressional Budget Office. Corresponding author: Tara Sinclair: tsinc@gwu.edu. The authors thank the editor
and two insightful referees, Olivier Coibion, German Cubas, Dean Croushore, Betty Daniels, Neil Ericsson,
Masami Imai, Dennis Jansen, Fred Joutz, Ken Kuttner, Kajal Lahiri, William Larson, James Morley, Charles
Nelson, Michael Owyang, David Papell, Tatevik Sekhposyan, Jay Shambaugh, Herman Stekler, Simon van
Norden, Tony Yezer, and Kei-Mu Yi for helpful discussions. The authors also thank participants at the
American Economic Association meetings, the Southern Economic Association meetings, the Symposium for
Nonlinear Dynamics and Econometrics, the International Association for Applied Econometrics conference, the
George Washington University Seminar on Forecasting, the Eastern Economic Association conference, Texas
A&M economics department seminar, the Pomona College Department of Economics Senior Colloquium Series,
the Wesleyan University Division II Seminar series, the Joint Statistical Meetings, the University at Albany
Economics Seminar, the University of Texas at Austin macroeconomics seminar, and the University of Houston
economics department seminar for useful comments. The authors gratefully acknowledge the support of the GW
Institute for International Economic Policy for this project. All remaining errors are our own.
686
©2020 The Department of Economics, University of Oxford and John Wiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 83, 3 (2021) 0305-9049
doi: 10.1111/obes.12415
about the impact of the Fed’s forecast errors on economic outcomes. In this paper, we
investigate this important question.
The Fed puts significant resources into producing accurate forecasts and is generally
judged the best forecaster for the U.S. economy, particularly for output and inflation
(see, e.g. Romer and Romer, 2000; Gamber and Smith, 2009; El-Shagi et al., 2014,
and Wright, 2019). Although the mean absolute errors of the Fed’s forecasts are large,
we fail to reject the null of unbiased and rational forecasts for our sample. If the
forecasts are rational, then the Fed’s forecast errors can be treated as exogenous at the
time the forecasts are made because the Fed incorporated all available information into
their forecasts.
1
Under this assumption, we compare the Fed’s forecasts to the
counterfactual of perfectly accurate forecasts. We consider a number of different
specifications, with our benchmark specification focusing on a weighted sum of
inflation and output growth forecast errors, following the approach of Sinclair et al.
(2012).
2
For the weights, we assume the Fed sets its federal funds interest rate target
according to a forward-looking Taylor Rule (Clarida et al., 2000). If the Fed’s policy
decisions can be well-approximated by a forward-looking Taylor Rule, as much
research suggests (e.g. Orphanides, 2001; Mankiw, 2002; Bernanke, 2010), then we
can interpret this weighted sum as being on the same scale as the fed funds rate. This
allows us to compare the magnitude of the forecast errors to that of monetary policy
shocks.
With exogenous forecast errors, we can produce counterfactual analysis to evaluate
the impact of the Fed’s forecast errors on the economy by implementing methods
commonly used in the monetary policy shock literature. We document that the Fed’s
forecast errors are large in absolute value, consistent with the findings of Sinclair et al.
(2012), where transformed into fed funds rate units the mean absolute error (MAE) is
over 175 basis points.
3
Furthermore, these errors are spread throughout the sample
rather than concentrated in a few key times. Although the Fed is on target on average,
the federal funds rate is far away from the Fed’s intended target most of the time.
Thus, these forecast errors could have large economic consequences.
Following Orphanides (2001) and Bernanke (2010), we assume the Fed bases
policy on the staff’s‘Greenbook’forecasts as the input for GDP and inflation. These
forecasts are prepared by the Federal Reserve staff before each Federal Open Market
Committee (FOMC) meeting, and are shared with the FOMC members before each
scheduled meeting. The FOMC members also make their own forecasts, however
Romer and Romer (2008) and Nunes (2013) have found that the Greenbook forecasts
1
Forecast errors from rational forecasts fulfil the requirements from Ramey (2016) to be macroeconomic
‘shocks’in the sense that they are exogenous with respect to current and lagged endogenous variables and they
represent unanticipated movements. These forecast errors capture all economic shocks between the forecast date
and the target date that were unanticipated by the Fed Many of these shocks might plausibly be deemed
impossible for the Fed to anticipate, so our analysis is in the form of a counterfactual where we suppose the Fed
had perfect foresight.
2
We do not consider interest rate projections by the Fed, but instead focus on forecasts of macroeconomic
conditions. For a study of central bank interest rate projections, see Bjørnland et al. (2020).
3
Based on our main 4 quarter ahead specification for the Taylor Rule for the sample period 1974Q2-2008Q2.
Note that although the MAE is large, the forecasts appear unbiased, that is, we cannot reject a zero mean, as
reported in Table 1.
©2020 The Department of Economics, University of Oxford and John Wiley & Sons Ltd
Fed forecast errors687
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