The Fed's Forecasting Fallacies
The Federal Reserve is perhaps the most prestigious and august institution of economic experts in the world. When the Fed forecasts, the world listens.
But are the forecasts any good?
We reviewed studies conducted by the Fed to gauge its own accuracy in making forecasts for important economic indicators. And we found that, by its own account, the Fed has proven to be incapable of accurately predicting the future.
A 2015 in-house study compiled all of the “Greenbooks”—the official forecasts made by the staff of the Fed Board of Governors for each meeting of the FOMC—from 1997 to 2008 and compared the aggregated forecasts to three simple statistical models.
The economists discovered that the Fed’s lack of accuracy in longer-term forecasts was essentially as bad if not worse than the simple statistical models. “We find that Greenbook forecasts significantly out-perform our benchmark forecasts for horizons less than one quarter ahead,” they wrote. “However, by the one-year forecast horizon, typically at least one of our forecasting benchmarks performs as well as Greenbook forecasts.”
The results of this study are consistent with one of the most well-proven hypotheses in social sciences: the superiority of algorithmic to clinical projections. In 2000, a group of researchers led by William Grove at the University of Minnesota conducted a meta-analysis of clinical (human) and mechanical (formal, statistical) predictions in over 150 prediction fields including finance, psychiatric and medical diagnoses, and educational outcomes. They found that despite the expertise of clinicians in all these fields, clinical predictions proved to be inferior. The Fed appears to be no different.
In another in-house study released last February, economists sought to estimate the level of uncertainty surrounding official forecasts as well as forecasts made by various government agencies, and other professional forecasters of macroeconomic indicators based on the historical trend of these institutions’ forecasting errors over the past twenty years.
They found that not only have historical Fed errors in forecasting been “considerable” but uncertainty surrounding FOMC forecasts of GDP growth, unemployment, and interest rate movements has actually grown since the Great Recession.
The study found only negligible differences in forecasting accuracy between the various institutions under scrutiny. In other words, the FOMC, the nation’s sole authority in crafting monetary policy, was not any better at forecasting macroeconomic indicators than private forecasters, even though some of the relevant drivers and variables, such as the federal funds rate, are actually set by the FOMC itself.
The Federal Reserve’s own research suggests that it cannot predict the macroeconomic future with any significant degree of accuracy over a time horizon of a year. Even with more complexity, data, technology and credentials, the evidence suggests they have gotten worse and not better over time.
The technocrats at the Fed have no special crystal ball. If world’s most hallowed economic institution can’t even predict the rates it sets with any degree of accuracy, isn’t it time investors started betting on uncertainty instead of building multi-year discounted cash flow models?