The Fed admits it's incapable of predicting the economy
Fed Chair Jerome Powell may have just admitted why the central bank has a terrible track record forecasting the economy.
In opening remarks at an event hosted by the Fed's Division of Research and Statistics, Powell urged central bank economists to think outside the box when trying to predict the future.
As it turns out, the economy is too complex for existing forecasting techniques.
“Even with state-of-the-art models and even in relatively calm times, the economy frequently surprises us,” Powell said.
“But our economy is flexible and dynamic, and subject at times to unpredictable shocks, such as a global financial crisis or a pandemic. At those times, forecasters have to think outside the models,” he explained.
The Fed’s policy-setting committee meets eight times a year to vote on interest rates. Behind the scenes, an army of researchers provides data and simulations about the state of the economy.
Fed officials use that data to make quarterly projections for economic growth, unemployment, and inflation.
This seems like pie-in-the-sky stuff, but it really isn’t. The Fed’s outlook on the economy influences its decisions on interest rates and money printing, which impact everyone.
The Fed’s poor track record
Recent history is filled with examples of the Fed’s dismal forecasting.
Arguably, the biggest miss happened during the pandemic when the central bank claimed that surging inflation was merely “transitory” and decided to do nothing about it. Until it was too late.
In March 2022, the Fed began raising interest rates to fight inflation. It would hike another ten times after that, bringing the federal funds rate to 5.5%, the highest in more than two decades.
“One of the surprises, at least to the Fed, was that inflation turned out to be much higher than its forecast,” said Larry Swedroe, head of economic and financial research at Buckingham Strategic Wealth.
“Its December 2021 forecast for 2022 inflation was for the core CPI to be between 2.5% and 3.0%. Inflation turned out to be more than double that,” he said.
The problem of poor forecasting seems to be getting worse over time, so maybe Powell’s interpretation of the economy being too complex is correct.
A 2019 study by professors Lillian R. Gaeto and Sandeep Mazumder found that “[Fed] chairs have become less accurate over time with their forecasts and have also tended to make fewer specific predictions.”
Where the Fed is now
With inflation cooling and markets doing the Fed’s work driving up interest rates, central bankers are divided about what to do next.
On the one hand, most officials think another rate hike is warranted, according to the minutes of the Fed’s September policy meeting. On the other hand, Powell has admitted that “financial conditions have tightened significantly” due to rising bond yields.
That’s a fancy way of saying that interest rates are rising without Fed intervention.
Speaking of forecasts, the Fed will deliver its next quarterly projections in December, where the odds of a rate hike are slim, according to CME Group’s FedWatch Tool. In fact, investors don’t expect the Fed to do much of anything until the spring.