We investigate how central bank forecasts of GDP growth evolve through time, and how they are adapted in the light of official estimates of actual GDP growth. Using data for 1988-2005, we find that the Federal Open Market Committee (FOMC) has typically adjusted its forecast for growth over the coming four quarters by about a third of the unexpected component of estimated growth in the four quarters most recently ended. We were unable to find any clear signs of systematic errors in the FOMC's forecasts. UK data for 1998-2005 suggest that the Bank of England Monetary Policy Committee (MPC) did not adjust its forecasts in this way, and that there were systematic forecast errors, but the evidence from the latter part of the period 2001-5 tentatively shows a behaviour pattern closer to that of the FOMC, with no clear signs of systematic errors.
Keywords: Forecasts; monetary policy; data revisions; vintages; Federal Reserve; Federal Open Market Committee; Bank of England, Monetary Policy Committee JEL classification: E47, E58, N12, N14
It is widely understood that discretionary monetary policy actions taken now have their effects on the economy not immediately, but in the future. It follows that rational decisions about such actions must be based on a forecast of the future course of the economy. Therefore, forecasts are a vital part of discretionary policy-making: the quality of the policy depends greatly on the quality of the forecasts.
For that reason, it is of great interest to explore the forecasting process. Indeed, the evaluation of forecasts of economic variables has engendered considerable research in recent years, as the monographs by Clements and Hendry (1998) and Clements (2005) reveal. In particular, assessing the track records of the various institutions and agencies engaged in macroeconomic forecasting has provided interesting reading: Pain (1994), Pepper (1998) and Mills and Pepper (1999) being notable examples for the UK. The purpose of this paper is somewhat different from these earlier studies, as it examines and compares how forecasts of GDP evolve in the light of new information in the form of GDP outturns. The examination is based on published information about forecasts made in the US by the members of the Federal Open Market Committee, and in the UK by members of the Bank of England Monetary Policy Committee.
2. The United States
Twice a year, in February and July, the Federal Reserve Chairman delivers a monetary policy report to the United States Congress. The report includes a table of the economic projections of the Federal Reserve Governors and Reserve Bank Presidents. The projections are for nominal and real GDP, the PCE price index, and the civilian unemployment rate. The February reports provide projections just for the current year (in the case of nominal and real GDP and the PCE price index, the percentage change from the fourth quarter of the preceding year to the fourth quarter of the current year; in the case of unemployment, for the fourth quarter of the current year). (1) The July reports provide projections for both the current year and the following year. As an illustration, the forecast table from the July 2004 report is shown in table 1.
The table always reports both the range of the forecasts of the Federal Reserve Governors and Reserve Bank Presidents, and the 'central tendency', which is normally a narrower range. For the purposes this paper, we have taken the mid-point of the narrower 'central tendency' range to be the FOMC's forecast.
3. The United Kingdom
Each quarter, the Bank of England publishes an Inflation Report incorporating the Monetary Policy Committee's forecasts of CPI inflation and GDP. Alternative forecasts are provided on the alternative assumptions that interest rates remain unchanged at their current level throughout the forecast period, and that they change in line with market expectations as the Bank of England interprets them from market prices. The forecasts are quarterly and run for two years into the future (since August 2004, the forecasts based on the 'market interest rate' assumption have run three years into the future). For the purposes of this paper, we use the forecasts based on the assumption that interest rates remain unchanged at their current level. We doubt whether switching to the alternative assumption would make any significant difference to the results.
The Bank of England forecasts are in the form of a probability distribution of each variable at each forecast date. For the purposes of this paper, we use the mean forecast for each date.
As an illustration, the Bank of England GDP forecast made in August 2004, assuming interest rates remain unchanged at their current level, is shown in table 2, reproduced from Bank of England (2004).
4. Assessing sensitivity to current events
It is reasonable to believe that the forecasts represent the current expectations of the policy-making bodies of the two central banks about …