Asymmetry, Complementarities, and State Dependence in Federal Reserve Forecasts

• Published date: 01 February 2020
• Author: JULIETA CAUNEDO,RICCARDO DICECIO,IVANA KOMUNJER,MICHAEL T. OWYANG
• Date: 01 February 2020
• DOI: http://doi.org/10.1111/jmcb.12590

DOI: 10.1111/jmcb.12590

JULIETA CAUNEDO

RICCARDO DICECIO

IVANA KOMUNJER

MICHAEL T. OWYANG

Asymmetry, Complementarities, and State

Dependence in Federal Reserve Forecasts

Forecasts are a central component of policymaking; the Federal Reserve’s

forecasts are published in a document called the Greenbook. Previousstudies

of the Greenbook’s inflation forecasts have found them to be rationalizable

but asymmetric if considering particular subperiods, for example, before

and after the Volcker appointment. In these papers, forecasts are analyzed

in isolation, assuming policymakers value them independently.We analyze

the Greenbook forecasts in a framework in which the forecast errors for

different variablesare allowed to interact. We find that allowing the losses to

interact makes the unemployment forecasts virtually symmetric, the output

forecasts symmetric prior to the Volcker appointment, and the inflation

forecasts symmetric after the onset of the Great Moderation.

JEL codes: C53, E47, E52

Keywords: forecast rationality, loss function, Taylorrule, Greenbook

forecasts, break tests.

THE FORECASTS THAT POLICYMAKERS rely on to set policy are

created as much on judgment and belief as on economic or econometric models. In a

The paper was previously circulated as “Federal Reserve Forecasts: Asymmetry and State-

Dependence.” The authors are grateful to the Editor, Ken West, and the Referees for their inputs which

have greatly improved the manuscript. The authors also thank Mengshi Lu, Mike McCracken, and Chris

Otrok for comments and suggestions. Diana A. Cooke, Hannah G. Shell, and Kate Vermann provided

research assistance. Viewsexpressed here are the authors’ alone and do not necessarily reflect the opinions

of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

JULIETA CAUNEDO is at Department of Economics, Cornell University (Email: juli-

eta.caunedo@cornell.edu). RICCARDO DICECIO and MICHAEL T. OWYANG areat Research Division, Federal

Reserve Bank of St. Louis (Emails: dicecio@stls.frb.org, owyang@stls.frb.org). IVAN A KOMUNJER is at

Department of Economics, Georgetown University (Email: ik334@georgetown.edu).

Received November 9, 2015; and accepted in revised form October 31, 2018.

Journal of Money, Credit and Banking, Vol. 52, No. 1 (February 2020)

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2018 The Ohio State University

206 :MONEY,CREDIT AND BANKING

speech made on July 10, 2007, then-Federal Reserve (Fed) Chairman Ben Bernanke

noted1:

The Board staff employs a variety of formal models, both structural and purely sta-

tistical, in its forecasting efforts. However, the forecasts of inflation (and of other key

macroeconomic variables) that are provided to the Federal Open Market Committee

(FOMC) are developed through an eclectic process that combines model-based projec-

tions, anecdotal and other “extra-model” information, and professional judgment.

These sentiments were echoed by former Fed Governor Daniel Tarullo, who sug-

gested that “many of the concepts invoked by monetary policy [...] are more direc-

tional indicators in assessing the economy than guides to individual policy decisions”

(Tarullo 2017). Beliefs of the Federal Open Market Committee (FOMC) members

about structural relationships among macrovariables are key to the decision making

process of the policy authority.2

Given the importance of beliefs in economic relationship for forecasting—and the

possibility that these beliefs can change over time—one might wonderwhether orhow

the Fed weighs these relationships. Even long-standing macroeconomic relationships

such as Okun’s law and the Phillips curvehave come into question by members of the

FOMC and the Board staff.3For example, on March 26, 2012, then-Fed Chairman

Ben Bernanke cited what he dubbed the “Okun’s law puzzle,” a divergence from the

historical statistical relationship between output and unemployment.4

While we may not directly observe the forecasting process, one way to evaluate a

policymaker’sbelief in certain economic relationships is to examine the joint behavior

of their forecasts. The forecasts that the Fed produces to conduct monetary policy are

contained in the Greenbook (or,more recently, the Tealbook). Made publicly available

at a 5-year lag, Greenbook forecasts have been used to study various aspects of Fed

behavior,such as whether the Fed’s forecasts are rationalizable or whether the Fed has

an informational advantage over the private sector.5In this paper, we study the Fed’s

forecasting behavior in an environment in which losses for forecast errors in inflation,

unemployment rate, and output growth are allowed to be asymmetric, interact with

each other, and vary over time.

1. The full text of the speech is available at: https://www.federalreserve.gov/newsevents/speech/

bernanke20070710a.htm.

2. Sargent,Williams, and Zha (2006) formalize how time-varying beliefs of the monetary authority

can affect inflation outcomes in the economy,and show how the Fed’s belief in a Phillips curve relationship

could account for Volcker’s disinflation.

3. Brayton, Roberts, and Williams (1999) argue that the standard view of the Phillips curve, which

documents the relationship between unemployment and inflation, has changed over time.

4. Thefull text of the speech and Bernanke’s proposed explanations for the Okun’s law puzzle can be

found at: https://www.federalreserve.gov/newsevents/speech/bernanke20120326a.htm.

5. For example, Swanson (2004) finds that the Fed’s forecast errors are, on average, biased and/or

correlated with the information available at the time the forecasts are made. Standard tests—for example,

those employing Theil–Mincer–Zarnowitz regressions—reject that the Fed forecasts are rationalizable

(e.g., Jansen and Kishan 1996); others (e.g., Romer and Romer 2000, Sims 2002) have determined that

Fed forecasts are not only rationalizable but encompass private sector forecasts. Other recent papers that

examine the Greenbook forecasts are Wangand Lee (2012) and R ossi and Sekhposyan (2011).