CHICAGO – Federal Reserve Bank of St. Louis President James Bullard discussed “Ghosts and Forecasts” as part of the Distinguished Speakers Series hosted by the CFA Society of Chicago on Friday.
During his presentation, Bullard evaluated Federal Open Market Committee (FOMC) forecasts of real GDP growth, the unemployment rate and inflation for 2014. He also discussed implications for forecasts and monetary policy in 2015.
Bullard noted that, in a forecasting sense, the FOMC has been surprised in the same way two years in a row. “The surprise has been that real GDP growth has been about as expected, but labor markets have improved more rapidly than expected, while inflation has remained low,” he explained.
“The nature of this surprise pulls the Committee in two different directions on monetary policy,” Bullard said. While a better-than-expected performance of the real economy suggests a more aggressive rate policy, he noted that lower-than-expected inflation outcomes weigh on the credibility of the FOMC’s inflation target of 2 percent and suggest a less aggressive rate policy.
The Monetary Policy Assumption
Since FOMC participants’ forecasts are submitted under an assumption of appropriate monetary policy, “this aspect of the exercise clouds the meaning of these Committee forecasts,” Bullard said. “This is a long-standing problem with FOMC forecasts.”
He discussed two scenarios regarding the monetary policy assumption. Should participants project possible outcomes under their own policy assumption? In this case, he noted, these participants might predict good outcomes. Alternatively, should participants project possible outcomes under a policy path likely to be chosen by the FOMC, even if these participants view a different policy as appropriate? These participants might predict less satisfactory outcomes in this scenario, he said. “Participants in fact use very different policy assumptions,” Bullard said, adding, “There is currently no resolution to this problem.”
Bullard noted that the FOMC forecasts are special because the Committee also decides on monetary policy. However, during his presentation, he treated the FOMC forecasts as unconditional statements of what will actually happen.1
Assessment of FOMC Forecasts for 2014
Bullard examined the FOMC’s forecast ranges for 2014 as well as the “central tendency”—which omits the three highest and three lowest projections—for three macroeconomic variables.
Focusing on growth, Bullard noted that the central tendency of the FOMC underestimated real GDP growth slightly in 2013 and overestimated real GDP growth in 2014. “This leaves the level of real GDP approximately correct over the two-year period,” he said. “In this sense, the Committee has been about right recently.”
Bullard then turned to a discussion of the FOMC forecasts for unemployment, considered to be one of two workhorse measures of labor market performance (along with nonfarm payroll employment). He noted that the FOMC missed the large decline in unemployment in 2014, expecting less labor market improvement than was observed. While the St. Louis Fed had the second lowest estimate for the end-of-year unemployment rate for 2014, he said that this estimate was still too high. “The private sector forecasting community has also been far too pessimistic on unemployment,” Bullard added.
In discussing inflation forecasts, Bullard noted that the FOMC overestimated inflation in 2014 as it did in 2013. The St. Louis Fed’s estimate was too high, along with the entire Committee’s, he said. The pattern is similar for forecasts of core inflation, which excludes food and energy.
In summary, he noted that real GDP growth has not been too different from expectations, labor markets have been stronger than expectations, and inflation has been lower than expectations.
“The Committee has been surprised in the same direction for two years in a row,” Bullard said. “This constellation of surprises pulls the Committee in different directions with respect to monetary policy choices.”
Implications for Current Monetary Policy
In traditional central banking, Bullard explained that when real macroeconomic performance exceeds expectations, policymakers chart a more aggressive course for interest rates. “The generally good real GDP growth, coupled with the sharp and surprising improvement in labor markets, suggests somewhat earlier and faster policy rate increases than would otherwise be the case,” Bullard said.
However, he noted the FOMC has not shifted market expectations toward an earlier and higher path for the policy rate in response to the surprises of the past two years. “Instead, market expectations for the policy rate have moved in the opposite direction, raising questions about the nature of the Committee’s reaction function to incoming data,” Bullard said.
“The Committee received better-than-expected news on the real economy over the last two years, and yet adjusted policy in the direction of maintaining low interest rates for a longer time,” he said. In looking at possible explanations for why the FOMC did not adjust in the normal way to this better-than-expected news, Bullard cited the surprisingly low inflation readings.
“The improvement in the real economy has not been accompanied with upward movements in inflation so far,” he said. However, Bullard added, “The level of inflation is not so low that it can alone justify a policy rate of zero.”2
Still, he cautioned that low inflation readings and declining inflation expectations may indicate a loss of credibility for the FOMC’s inflation target. “An important tenet of modern central banking is that a central bank must protect its credibility with respect to its inflation goal,” Bullard said.
1 For a technical discussion on this and related issues, see Bullard’s “Discussion of Ellison and Sargent: What Questions Are Staff and FOMC Forecasts Supposed to Answer?” on March 30, 2009.
2 For more discussion, see Bullard’s presentation on Nov. 14, 2014, “Does Low Inflation Justify a Zero Policy Rate?”