The Federal Reserve is now well into a sustained phase of monetary policy tightening. Since December 2015, the Federal Open Market Committee (FOMC) has raised its federal funds rate target in four steps by a total of one full percentage point. And soon the Fed will begin reducing the size of its balance sheet, as well, by allowing some of its bond holdings to mature without reinvestment. Any sense of urgency behind these moves towards tighter policy seems misplaced, however, given the recent behavior of inflation. Although inflation had been approaching the FOMC’s two percent target towards the end of last year, it has fallen back noticeably in 2017 to a pace closer to 1.5 percent. Why would the Fed continue tightening policy against this backdrop of falling inflation?
The answer is that the FOMC is wisely adjusting its policy in response to where it expects inflation to go in the future, instead of where inflation is today. This can be seen from the latest projections made by FOMC members, which reveal their confidence that inflation will, in fact, converge to back to target even as interest rates continue to rise over the next several years. The Financial CHOICE Act of 2017, already passed by the House of Representatives and now awaiting action by the Senate, would help clarify the important role that forecasts play in the FOMC’s policymaking strategy and would facilitate, as well, a more detailed assessment of their accuracy.
As we discussed in a previous column, the CHOICE Act instructs the FOMC to adopt a specific monetary policy rule linking its funds rate target to measures of inflation and the output gap, variables that reflect the Fed’s dual mandate to stabilize prices and provide for maximum sustainable employment. One rule that takes exactly this form was famously proposed by John Taylor in 1993. It calls for the Fed to adjust its target r for the funds rate in response to deviations of inflation p from its two percent target and movements in the output gap y according to the formula
r = 2 + p + (1/2)y + (1/2)(p – 2).
The graph below compares the historical trajectory for the federal funds rate, shown in green, to values prescribed by two versions of this rule, which differ only in the way that inflation and the output gap are measured. The blue line, labelled “forecast rule,” uses the Fed’s own one-year-ahead forecasts of inflation and the output gap, using data from the “Greenbook” that is prepared by the research staff at the Federal Reserve Board prior to each FOMC meeting; these data are publically available from 1987 through 2011 through the Federal Reserve Bank of Philadelphia’s website. The red line, labelled “lagged data rule,” uses instead values for the actual inflation rate and output gap from the previous year, reflecting information that the FOMC could have used in lieu of its own forecasts at the time its decisions were made.
This graph points to two conclusions. First, while settings for the funds rate prescribed by the two rules move up and down together, deviations as large as one, two, or even three full percentage points between them regularly appear. This observation reassures us that the Fed is by no means facing an unprecedented situation today, where policy actions based on forecasts look considerably different from those based on lagged data. Second, the green line showing the actual trajectory for the funds rate tracks the forecast-based blue line much more closely than the data-based red line. This observation confirms that forecasts have always played an important role in the Fed’s policymaking strategy.
How accurate have the Fed’s forecasts turned out to be? The evidence to date is mixed. A 2000 paper by Christina and David Romer finds that Greenbook forecasts of inflation are considerably more accurate than private forecasts of the same variable. In the conclusion to their paper, in fact, Romer and Romer suggest that the Fed release its Greenbook forecasts in a more timely manner, so as to provide the public with better information on the future path for inflation. The FOMC could easily do this, under the CHOICE Act, by making those forecasts available as inputs to its chosen policy rule.
A more recent article, by Tara Sinclair, Fred Joutz, and H.O. Stekler, however, suggests that the Fed has great difficult forecasting recessions, even looking just one quarter ahead. Another advantage to the CHOICE Act would accrue if, by releasing its forecasts for inflation and the output gap, the Fed provided to outside researchers a consistent dataset that could be used to explore, more systematically, how accurate those forecasts are and, by extension, how much more successful a policy strategy based on forecasts can be.
Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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