The Fed Opens Up on Its Economic Forecasts

The Fed just recently started releasing its forecasts for the economy on a quarterly basis instead of a semi-annual basis. This means the Fed’s forecasts are more timely and can be used for comparisons in terms of whether incoming economic data are matching what the Fed expects. The most recent set of forecasts indicates that that the next two quarters are going to be very sluggish, that core inflation is going to be moderate, and that overall inflation is not going to jump excessively. 

The latest forecast was made for the October 30-31, 2007 FOMC meeting and was made public on November 20 when the minutes of the meeting were released. The forecasts are compiled from individual forecasts from each Federal Reserve Board governor and each of the regional Fed bank presidents. The central tendency throws out the bottom three and the top three forecasts.

The below table shows “point estimates” for the Fed forecasts which are simply averages of the upper and lower ends of the central tendency range.

One shortcoming of the Fed forecasts is that only yearly growth rates are made public. Growth rates are fourth-quarter-over-fourth quarter for 2007, 2008, 2009, and 2010. The unemployment rate is the fourth quarter average. There are no ongoing quarterly forecast numbers released to the public.

Implied Near-Term Forecasts

To get an idea of what the Fed expects for the fourth quarter of 2007 and first quarter of 2008, one has to make certain assumptions regarding the relative strengths of the various quarters and then one can “back out” the quarterly numbers from the fourth-quarter-over-fourth-quarter percentages. Typically, one works with quarterly levels for the data and then calculates the quarterly annualized percentages. In this process, the ratio of one quarter to the prior quarter is raised exponentially by a factor of 4 (the number of quarters in a year) to get the annualized percentage. To back out levels for each quarter from assumed quarterly growth rates (that is, educated guesses based on Fedspeak and commentary) one exponentially raises the percentages by 0.25, leaving the not annualized ratio to calculate quarterly levels in the forecast.

To get an idea for the Fed’s current quarter forecast, the task is simple since three quarters of data were known for 2007 at the time of the latest round of forecasts and only one number for each series for the fourth quarter is consistent with the fourth-quarter-over-fourth quarter forecasts.

The implicit forecasts by the Fed for the current quarter are:

• Real GDP, 1.5%
• PCE price index, 2.5%
• Core PCE price index, 2.0%

Certainly, we had an upward revision to third quarter GDP (from 3.9 percent to 4.9 percent) but that has little effect on the Fed's fourth quarter view (although the revision will affect the 2007 annual numbers in the Fed’s next forecast due out in February 2008).

What about the quarterly pattern for next year? Fedspeak and commentary in the forecasts can give us an idea of relative strength for various quarters.  For example, latest Fed minutes stated that “The subpar economic growth projected in the near term was not expected to persist.”  That is, the below 2 percent growth expected in the next couple of quarters is not expected to last. But it still is expected that growth will be “below trend over the next year or so.” Below trend would be below 2.5 percent (discussed below). So, one could assume that the economy is still soft in the first quarter due to negative housing investment growth and with sluggish consumer spending. Then quarterly growth rates gradually improve during 2008, reaching potential at the end of the year.

The following table shows some assumed quarterly growth rates for GDP, the PCE price index, and the core PCE price index that result in fourth-quarter-over-fourth-quarter growth rates forecast by the Fed for 2007 and 2008.

One Set of Assumed Growth Rates That Are Consistent

With The Fed’s Economic Forecasts

For the same Q4/Q4 real GDP forecast in 2008, if the latter quarters were stronger, then the earlier quarters would have to be even weaker to have the same annual outcome.

Not a whole lot can be done with the inflation numbers in order to have a rational forecast reaching the Fed’s annual projection and incorporating recent information. The Fed expects overall inflation to gradually come down from its current pace to end up below 2 percent annually. The implicit current pace is 2.5 percent annualized and the Fed appears to be counting on some help from a decline in energy prices in the first quarter to get a very favorable number for that period, one that would bring the annual figure below 2 percent if overall inflation is at 2 percent for the rest of the year.

For core PCE inflation, the Fed has an implicit starting point of 2 percent annualized growth for the current quarter. This does not leave much wiggle room for a forecast that results in a gradual easing in inflation to 1.8 percent. The Fed certainly would admit that quarterly numbers can jump around but the forecast seems to call for core inflation that has a slow trend downward.

Long-Term Economic Beliefs Implied in the Fed Forecasts

One of the primary reasons for the Fed to publish its forecasts more frequently is to get the public to better understand the Fed’s economic objectives. With the Fed publishing forecast that go out three years, the third year forecast is really more of a statement of objectives than a realistic forecast. For the most part, the third year forecast tells us the following:

• The Fed sees long-term potential growth in real GDP as around 2.5 percent. This is lower than the 3 percent used not long ago.
• The Fed sees overall inflation and core inflation running at the same rate in the long run.
• The Fed has an implicit target for inflation of between 1-1/2 percent and 2 percent.

The idea is that if incoming economic data cause the forecasts to be missed, then monetary policy would be adjusted to bring the economy back in line with the long-term forecasts.

The bottom line

The bottom line is that the Fed is expecting very soft economic growth in the current quarter and in the first quarter of next year. Also, the Fed expects and is planning for overall and core inflation to eventually drop and stay below 2 percent annualized growth. While these numbers are relatively clear, what is not clear is what changes in monetary policy will result in these forecasts coming to fruition. When the forecasts are made, each governor and district president assumes what the appropriate monetary policy is over the forecast horizon. The forecasts may or may not include a cut in interest rates on December 11.