There are times when the Fed's policy actions are relatively easy to predict, and times when it is far more difficult. Plotting the forecast errors for GDP growth and inflation can give us some graphical insight as to how the Fed reacts to different situations.
The figure below shows forecast errors for inflation and real GDP growth. The forecast errors are constructed by subtracting the latest Blue Chip forecast from the relevant quarter's advance report on actual GDP growth. The actual GDP growth rate that the Blue Chip forecasts are compared to in each quarter is based on the most recent estimate available from the government at that time.
Because it takes the Bureau of Economic Analysis a good bit of time before it can release an accurate final estimate of quarterly GDP growth, advance estimates are issued in the first month immediately following the end of a quarter. These advance estimates contain most of the information about GDP and are hardest to forecast. Two revisions, preliminary and final, are released in the second and third month after the end of each quarter. For example, advance first-quarter estimates are issued in April, preliminary estimates are issued in May, and final estimates are issued in June. Therefore, when advance data for the second quarter is released in July, the available GDP growth estimate for the calendar year includes the final estimate for the first quarter and the advance estimate for the second quarter. A positive forecast error in July would indicate that at that point in time, the available GDP growth estimate is above the Blue Chip forecast for the year.
The forecast errors should reflect the new information contained in the GDP report. In the case of GDP growth, if the forecast errors are positive, by implication GDP may be growing faster than the estimate of potential. If the forecast errors are negative, by implication GDP is likely to be growing below potential.
If both forecast errors are positive--that is, if inflation and growth are both unexpectedly high--then the points will lie in the red region of the figure, indicating the need for a tighter policy. If both forecast errors are negative, indicating surprisingly slow growth and low inflation, then the points will lie in the green sector, suggesting the need for a looser policy. If the points lie in the other two blue quadrants, where one forecast error is positive and the other is negative, there is no clear indication for policy.
Since the beginning of 1994, GDP growth forecast errors (measured on the vertical axis) have tended to be positive, mainly lying above the horizontal axis. Generally, the inflation errors have been negative, with the points lying to the left of the vertical axis. In the majority of the cases, then, the forecast errors have been in the blue area, where growth is surprisingly high and inflation is surprisingly low. Therefore, since 1994, it has not been clear what, if anything, should be done with monetary policy. In fact, since 1994, the first quarter of 2000 was the only instance in which forecast errors for both inflation and GDP growth were positive (that is, in the red sector). So we should not be surprised that the Fed would see the need to tighten monetary policy.
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