Do Wall Street Economists Believe in Okun's Law and the Taylor Rule?

Article excerpt

Abstract

We use data from the Wall Street Journal's semi-annual survey of professional economists to test whether individual economists' six-month-ahead predictions of real GDP growth, unemployment, short-term interest rates and inflation reflect Okun's Law and the Taylor Rule. We conclude the economists believe real growth is less responsive to unemployment-rate changes than the textbook version of Okun's Law; we also find the economists believe the Federal Reserve sets short-term interest rates by placing more weight on unemployment and less weight on inflation than the Taylor Rule prescribes.

Keywords Okun's Law * Taylor Rule * Forecasting

JEL codes E32 * E52 * E58

The Wall Street Journal has conducted a regular survey of professional economists for over 25 years, asking the economists for their forecasts of several macroeconomic variables. The panel is composed mostly of business economists from the financial and economic consulting industries. Unlike such surveys as the Livingston Survey or the Survey of Professional Forecasters, the Journal identifies the forecasts by forecaster name and employer in its prominent, feature stories on the forecasts. Presumably these economists give presentations of these forecasts to customers and business groups, explaining their reasoning. This suggests that these forecasts should reflect any interrelationships among forecasts that the economists employ in producing their predictions. One possible relationship is Okun's Law, which links changes in the unemployment rate to the growth rate of real output. Another is the Taylor Rule, which prescribes that the Federal Reserve set the short-term interest rate it targets based on deviations of output and inflation from their targets.

We investigate whether forecasts made by these professional economists reflect Okun's Law or the Taylor Rule. We draw forecasts from 1986-1988 and from 19992007, the periods in which the Journal reports forecasts of all the variables needed for our investigation. We proceed by estimating standard models of Okun's Law and the Taylor Rule on economists' predictions and examining whether they conform to the conventional parameterizations of these relationships. To preview our results, we find that the economists' real-growth-rate predictions generally reflect less responsiveness to predicted unemployment-rate changes than the textbook version of Okun's Law, and that their interest-rate predictions generally reflect less weight on predicted inflation and more weight on predicted unemployment than the Taylor Rule prescribes.

We believe our paper makes a novel contribution to the literature assessing professional economists' forecasts. Much of this literature seeks to ascertain the quality of forecasts of individual economic variables with respect to unbiasedness, accuracy visà-vis benchmarks, and homogeneity.1 Instead of ascertaining the forecasting accuracy of the economists, we focus on whether the forecasts are consistent with relationships that form part of the basic macroeconomic conventional wisdom.

The rest of the paper is organized as follows. Section 1 briefly reviews the literature on Okun's Law and the Taylor Rule. Section 2 describes our data and the models estimated. Section 3 presents and discusses our empirical results. Section 4 draws our conclusions.

1 Literature review

If stable empirical relationships exist among macroeconomic variables, we would expect the public forecasts of professional economic forecasters to be generally consistent with these relationships. One such relationship between real output and unemployment is known as Okun's Law, which Alan Blinder (1997, p. 241) referred to as a "truly sturdy empirical regularity" that "closes the loop between real output growth and changes in unemployment with stunning reliability." Another, more recent, relationship is between the short-term nominal interest rate, the inflation rate and the output gap known as the Taylor Rule, which Taylor (1993) found to explain much of the variation in the short rate in the early years of the Greenspan era. …