IE 11 is not supported. For an optimal experience visit our site on another browser.

How clear is the central bank’s crystal ball?

When it comes to forecasting U.S. inflation, the Federal Reserve staff's crystal ball appears to be about as clear, or in some cases foggy, as the private sector's.
/ Source: The Associated Press

When it comes to forecasting U.S. inflation, the Federal Reserve staff's crystal ball appears to be about as clear, or in some cases foggy, as the private sector's.

That's the conclusion of a pair of academics who compared Fed staff forecasts with those of private-sector economists over a period of three decades.

A decline in the volatility of inflation since the mid-1980s, known in economic circles as the Great Moderation, "has evened the playing field between the Fed and private sector" and has led to an erosion of the Fed's relative forecasting advantage, Lafayette College economists Edward Gamber and Julie Smith wrote.

Still, the Fed staff's forecasting errors "still appear to be slightly smaller than the private sector's," they wrote.

The economists compared the Fed staff's Greenbook forecasts, which are prepared for each Federal Open Market Committee meeting, with private-sector forecasts such as the Survey of Professional Forecasters and Blue Chip Economic Indicators through 2001. They compared the Greenbook and the Survey of Professional Forecasters since 1968, and began their Greenbook and Blue Chip comparison in 1980. Greenbook forecasts are released to the public with a five-year lag, so a more up-to-date comparison isn't possible.

On Tuesday, the Fed started releasing inflation, output and unemployment forecasts by FOMC policy makers — but not staff — on a quarterly basis in an effort to improve communication with the public. It used to issue those FOMC forecasts only twice per year.

Still, Gamber and Smith's findings are relevant even though they don't examine FOMC policy-maker forecasts. A 2001 study by two St. Louis Fed economists found that, through 1996, FOMC inflation forecasts were not as accurate as the staff's Greenbook forecasts. But, they were better than the private sector's, so any gap between private-sector and FOMC inflation forecasts has probably narrowed as well.

If inflation has become less volatile, it stands to reason that it would be easier for analysts to predict. But the paper suggests more is at work than just the Great Moderation.

Gamber and Smith found that improved Fed transparency since the mid 1990s — when it started announcing changes to interest rates and, later, issuing policy statements explaining its decisions — has also narrowed the Fed staff's edge over the private sector.

Noting that other economists had previously attributed the Fed's forecasting prowess in part to the size of its research operation, Gamber and Smith observed that "the Fed is getting a smaller bang for its buck."

One practical effect of the convergence between Fed and private-sector forecasts, the authors said, is that Fed policy changes don't affect the bond market as much as they used to. Back when the Fed had a big forecasting advantage, higher official interest rates suggested the Fed had additional information about future inflation that the market didn't have, leading to higher market interest rates.

"During the most recent Fed tightening episode however, long-term interest rates did not rise ... which is consistent with an erosion of the Fed's forecasting advantage," the authors wrote.

"Finally, with respect to the Fed's movement toward greater transparency, our findings suggest that the potential destabilizing effects of Fed inflation forecasts has declined, if not disappeared, with the erosion of the Fed's forecast advantage," they wrote.