Self-Fulfilling Fed

Article excerpt


In economics, sometimes believing makes it so. When people are optimistic about the economic outlook, they behave in ways that help realize their expectations.

If consumers are confident about their future incomes and don't foresee higher taxes or inflation, they are more willing to make spending commitments. The stronger demand for goods and services in turn stimulates business investment, job creation, and wage growth, further fortifying economic optimism. Pessimism about the future can be similarly self-fulfilling.

Economic expectations are influenced by personal experience, past trends and forecasts. Especially influential are the forecasts made public by the Federal Reserve's policymaking open market committee (FOMC).

Take inflation. When the FOMC forecasts continued price stability, it is influencing the public's expectations and behavior in a way that helps to assure that outcome. Optimism has its payoffs. If inflation were to get away from the Fed and policymakers to lose credibility, expectations of worsening inflation could trigger behavior that would contribute to bringing about that result.

Twice a year the Fed chairman presents to the Congress the FOMC's economic forecast for the current and following year, which includes the committee's prediction of inflation. In the last seven years, the FOMC has twice changed the inflation measure used in its forecasts, both times shifting to a tamer inflation series.

In the years prior to 2000, the FOMC forecast the overall, or headline, Consumer Price Index (CPI). In early 2000, during rising inflation, the FOMC shifted from the CPI to forecasting the more subdued overall personal consumption expenditure (PCE) price index. During the 1990s, the PCE inflation rate had averaged about a half point less per year than the CPI inflation rate, not a small amount.

The explanation for the switch was relegated to a footnote in the Fed's report to Congress, though the reasons given were substantive: The CPI was upward biased because it used fixed weights, whereas the PCE inflation rate reflected the changing composition of spending, was a more comprehensive measure, and was more consistent over time.

The second change came in mid-2004, again when inflation was rising. The FOMC switched from forecasting the total PCE to forecasting core PCE inflation, which excludes food and energy prices, some of which are volatile and can distort the trend in underlying inflation. In the decade prior to the change, the core PCE inflation rate had averaged about a half-point less a year than the total PCE rate. …