The FOMC & its Forecasts

The “Teal Book”:

Rest in peace, Green Book and Blue Book. The Federal Reserve‘s confidential briefing books that policymakers have used for decades received an overhaul for the Federal Open Market Committee meeting that begins today. The new document merges the two prior books, named for the color of their covers, into one: the Teal Book.

The “Teal book” is released with a five year-lag, just like the transcripts. We have now access to the December 2010 Teal Book or “Report to the FOMC on Economic Conditions and Monetary Policy

As you would expect, it´s a long (100 pages) document. What caught my eye was the “Long-Term Outlook” on page 32. The panel below sets out the Outlook (Forecast) for Real Output Growth, Unemployment Rate, Headline & Core PCE Inflation, Effective Federal Funds Rate and 10-year Government Bond Yield.

The growth rates are Q4/Q4 rates while for Unemployment, FF Rate and Bond Yield it´s the Q4 average for each year.

Teal Book_1

Teal Book_2

Two things caught my eye:

  1. The large forecast errors, mostly with the same sign
  2. The almost perfection of the unemployment rate forecast

Is there a worldview (model) consistent with those forecasts? A nice candidate would be a Phillips Curve worldview.

Imagine that the FOMC were pretty confident in their unemployment rate forecast. Via “Okun´s Law”, a falling unemployment rate would be consistent with a rising RGDP growth. Via the Phillips Curve, a falling unemployment rate would also be consistent with an initially very low inflation rate, especially a low core inflation rate unburdened by oil price increases (that were taking place at the time the forecasts were made), reflecting the initial extremely low utilization rate. Over time, inflation would rise to reflect labor market tightening.

With that, the policy rate (FF) would start to “normalize” and long-term bond yields would rise in accordance with both higher real growth and higher inflation.

The results, however, contradicted the worldview. Unemployment fell almost exactly as forecast. However, real growth never picked up. Initially, core inflation was much higher than expected and dropped significantly over time. The exact opposite of the FOMC´s forecast.

With no increase in real growth and with inflation far below “target”, policy “normalization” was not an option! That is, until the FOMC couldn´t hold itself any longer, raising the FF rate in December 2015.

Policy tightening, however, began much earlier, in mid-2014, with the start of Fed “talk” of raising rates. Not surprising that at that point commodity prices turned down and the dollar began to rise.

It´s way past the time the FOMC changes it´s “worldview”!

Update: Bullard says:

The U.S. central bank’s inflation and employment goals have essentially been met and it would be “prudent” to edge interest rates higher, St. Louis Fed President James Bullard said on Friday.

You could say they have (even with core inflation a bit below target). As you see from the forecasts made in 2010, the targets would have been “met” only with much higher rates. Maybe that´s why he uses the word “prudent”. Does he feel they were “lucky” to “meet” the targets with rates far below the ones “deemed” necessary originally?

Or does the outcome imply that interest rates are irrelevant? In that case, what would be the relevant monetary policy measure? What is the “alternative” policy measure indicating?

Will it be enough if there are no rate hikes in 2016?

Janet Yellen and the Federal Reserve are on another planet:

That’s the message from global investors who are sending the Fed a big distress call to come back to earth.

The Fed is still predicting four interest rate hikes this year, but the market now forecasts zero hikes in 2016.

The closely watched Fed Futures market now has a nearly 60% probability of no rate hikes at all this year.

It’s a dramatic U-turn from only a month ago when the market was pricing in a 75% probability the Fed would increase rates at least once in 2016.

New York Fed Dudley said:

New York Fed President William C. Dudley said in an interview with Market News International that policy makers are “acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward.”

Only “may be”? Much more is needed, especially since lately we´ve had the Fed and the ECB/BoJ pulling in opposite directions. Some policy coordination would greatly increase their productivity!

I believe that even if there are no rate hikes in 2016, that will not be near enough to get the economy “unstuck”!

What´s needed is a reversal of nominal growth expectations that translates into a reversal of actual nominal growth. For the past year and a half, this has been sliding down and if the Fed remains hostage to its policy framework of “gradual normalization” underpinned by “Phillips Curve thinking”, the outcome will be dire!

Fed Wrong

The Fed is set on tightening

The Phillips Curve crowd, led by Yellen, thinks falling unemployment will bring more inflation. But have some qualms:

Fed Minutes: Officials in December Expressed ‘Significant Concern’ About Low Inflation

Minutes also show worries about global growth and strong dollar

“Because of their significant concern about still-low readings on actual inflation and the uncertainty and risks present in the inflation outlook, (officials) agreed to indicate that the (Fed) would carefully monitor actual and expected progress toward its inflation goal,” the Fed said in minutes of its Dec. 15-16 policy meeting released Wednesday.

But they hiked rates anyway!

Then there is the “financial crisis” group led by Fischer

For Vice Chairman Staley Fischer markets are wrong. There will be more tightening:

Fed’s Fischer Says Four Interest-Rate Increases Possible This Year

Fed vice chairman in CNBC interview says market expectations of two interest-rate increases are ‘too low’

Fischer worries Fed can’t head off, contain financial crises

Fischer’s comments suggest that the central bank may need to rely more on monetary policy to restrain financial excesses than it has in the past. In fact, he told the conference that it might be necessary for the Fed to increase interest rates if financial markets were overheating, though the first line of defense should be the use of regulatory measures to head off bubbles.

A rate hike was the “mutually satisfactory” outcome.

Janet´s occasionally funny non-sequiturs

From her speech today at The Economic Club of Washington, DC:

N.S. 1Continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2 percent objective over the medium term.”

But inflation has been moving away from the target, despite falling unemployment!

N.S. 2 The Fed has held its benchmark federal-funds rate near zero for seven years. When it raises the rate, it will be a sign that the economy has “come a long way” toward recovering from the 2007-09 financial crisis. In that sense, it is a day that I expect we all are looking forward to.”

Five years ago, the economy had already recovered from the financial crisis. Why did the Fed wait so long to “tell us”? Maybe only now they got tired of their “extended vacation”.

N.S. 3 Were the [Fed] to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals”. “Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”

That´s exactly what the Fed has been doing, inadvertently, over the past year by indicating “the time is coming”!

N.S. 4 “I anticipate that the neutral federal funds rate will gradually move higher over time.” “In September, most [Fed officials] projected that, in the long run, the nominal federal funds rate would be near 3.5 percent, and that the actual federal funds rate would rise to that level fairly slowly.”

That´s just misplaced faith. By their actions, the Fed is likely stifling the rise in the neutral FF rate.

PS The power of words: Yellen talks and the DOW tumbles

Non sequiturs

Where does Yellen get these crazy ideas – 2

Yellen and other high-ranking members of the FOMC are partial to the following type of statement:

There is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further.

One of those forces is the price of oil.

The charts below show that this particular idea lacks foundation. Between 2004 and 2008, there were two back-to-back oil price shocks. The first from 2004 to 2006 and the second in 2007-2008.

Yellen Crazy Ideas2

What to expect when there is an adverse supply shock like an increase in the price of oil? The dynamic AD-AS model tells us that inflation will tend to rise and real growth to fall. In that situation, the best the Fed can do is to maintain nominal spending (NGDP) growing in a stable manner.

Looking at the left side charts, we see that´s exactly what happened, at least until early 2006. Inflation went up a bit and real growth decreased somewhat, but nominal spending growth remained stable. Bernanke took over the Fed as the first oil shock was ending and immediately (given his inflation targeting “preferences”) allowed NGDP growth to falter.

Soon after, the second oil shock materialized, putting pressure on headline inflation (not shown). NGDP growth continued to fall, magnifying the fall in real growth from the oil shock. We know that after mid-2008 NGDP growth tumbled, being negative for the first time since 1937.

The right hand side of the chart depicts the economy over the last five years, after the worst of the crisis passed. Note that inflation was slowly falling long before the drop in oil price in mid-2014.

Why do they expect inflation to move higher, if they are constraining NGDP growth? They´ll be surprised when real growth (in addition to inflation) falls when oil prices dropped!

An economic impossibility theorem: You cannot have rising inflation without rising NGDP growth!

Where does Yellen get these crazy ideas?

Maybe from her Phillips Curve upbringing. In her Congressional Testimony today, she said:

The U.S. economy is “performing well” and could justify an interest rate hike in December, Federal Reserve Chair Janet Yellen told Congress on Wednesday.

“I see underutilization of labor resources as having diminished significantly,” Yellen said, with inflation expected to rise over the medium term.

The Fed is “expecting the economy will continue to grow at a pace to return inflation to our target over the medium term,” she said. “If the incoming information supports that expectation … December would be a live possibility” for a rate increase, Yellen added.

As James Alexander wrote recently:

The central banks seem to define inflation as inflation two years out, that is, expected inflation based on their own “official” expectations. And, therefore, central bankers are on target with their own targets.

While she expects inflation to rise over the medium term, market based inflation expectations have fallen significantly since July.

Yellen Crazy Ideas_1
Neither does history provide evidence for her “wishes”. The chart shows nominal and real growth and inflation over a five year period following the 1990/91, 2001 and 2008/09 recessions!

Yellen Crazy Ideas_2

Why have such a large research staff if their findings are ignored?

Yellen earlier this year:

“We will be looking at wage growth” as a signal of inflation though “I wouldn’t say either that that is a precondition to raising rates.” [Translation: I´ll raise them anyhow!]

Results over two decades for the general theme: Are wages useful in forecasting inflation?



Researchers have extensively studied how wage data might help predict future price inflation. The overall conclusion of the literature is that wages generally provide less valuable insight into future prices than some other indicators. In fact, models that do not incorporate wages often result in superior inflation forecasts.

In 2000:

Concluding Observations

The cost-push view of the inflation process that is implicit in the expectations augmented Phillips curve model assigns a key role to wage growth in determining inflation. In this article, I evaluate this role by investigating empirically both the presence and stability of the feedback between wage growth and inflation during the U.S. postwar period, 1952Q1 to 1999Q2. The results indicate that wage growth does help predict future inflation over the full sample period considered here.

However, this finding is very fragile, and it appears in the full sample because the estimation period includes the subperiod 1966Q1 to 1983Q4 during which inflation steadily accelerated.

Wage growth does not help predict inflation in two other subperiods, 1953Q1 to 1965Q4 and 1984Q1 to 1999Q2, during which inflation remained low to moderate.

In contrast, inflation always helps predict wage growth, a finding that is both quantitatively significant and stable across subperiods. These results thus do not support the view that wage growth has been an independent source of inflation in the U.S. economy.

In 1996:


Many analysts have heralded the slow growth of unit labor costs during recent years as a harbinger of continued low inflation. In this article, we investigate the usefulness of labor costs as a predictor of inflation. Earlier studies have focused on in-sample causality tests. Our in-sample causality tests indicate that, during the pre-1980 period, wage growth did have information content for future core inflation (CPIC) but not overall CPI inflation. During the post- 1980 period, however, this information content has disappeared.

Additionally, we find that the evidence of inflation causing wage growth is quite robust across samples.

In contrast with earlier studies, we also investigate out-of-sample forecasts of inflation using labor costs in an error-correction model. Out-of-sample forecasts offer the ultimate test of whether wages help predict future inflation. For recent years, the out-of-sample forecasting exercises offer no evidence that wage growth contributes to any reduction in forecast errors compared with univariate autoregressive models of inflation. Therefore, when assessing future inflation developments, these results suggest that policymakers and analysts should put little weight on recent wage trends.

His Excellency, the Model, suggests…

The Federal Reserve Board released an updated version of its large-scale model on the U.S. economy that may hold clues into why policy makers pivoted at their meeting earlier this week toward a December interest-rate increase.

The revised inputs and calculations on Friday suggest the economy will use up resource slack by the first quarter of 2016, according to an analysis by Barclays Plc, and that also indicates Fed staff lowered their near-term estimate for how fast the economy can grow without producing inflation — a concept known as potential growth…

…In the current model, “the long-run growth rate is two-tenths lower” at 2 percent, Barclays said. FOMC participants forecast the economy’s long-run growth rate at 2 percent in September.

The unemployment rate stood at 5.1 percent in September, and the Fed model assumes little change from that level, dipping to a low of 4.8 percent in a forecast horizon that extends to 2020, according to Barclays. FOMC officials estimated full employment — or the level of the unemployment rate consistent with stable prices — at 4.9 percent last month…

…The model, known as FRB/US and updated periodically, is a series of calculations put together by Fed staff that sketch out how broad measures of the economy would change based on a set of defined parameters. The staff also constructs a bottom-up forecast for policy makers before each FOMC meeting. U.S. central bankers use the models and forecasts as reference points, not sole determinants of their decision-making.

This is nothing short of fantastic!

For the past five years, since partially recovering from the “Big Slump” of 2008-09, real output (RGDP) has been crisscrossing the “potential” growth rate. On the last view, it seems to be dying to undercrosss it! From the behavior of NGDP growth, it will likely “manage” that over the coming quarters.

FRB-US Model_1

Meanwhile, unemployment has taken a dive, but that has not put upward pressure on any measure of inflation, that has been “relenting” (and doing so long before the oil price drop since mid-2014).

FRB-US Model_2

Maybe the future will be significantly different from the recent past, with, for example, low unemployment finally pressuring inflation according to the Fed´s preferred Phillips Curve assumption in the model, given that real growth is (and has been for a long time) at “potential”.

However, before putting a lot of faith in these forecasts, what is the model´s “record of accomplishment”?

The tables below start with the first “Forecast Material” from April/11. Then from March/13, March/14 and the latest from Sept/15. In parenthesis, the realized value for the year. You immediately notice the “one-sided” errors of the forecasts, which mostly over forecast growth, unemployment and inflation!


RGDP Unemploym. PCE PCE-Core
2011 3.2 (1.6) 8.6 (8.5) 2.5 (2.5) 1.5 (1.5)
2012 3.4 (2.2) 7.8 (7.9) 1.6 (1.9) 1.5 (1.9)
2013 3.9 (1.5) 7.0 (6.7) 1.7 (1.4) 1.7 (1.5)


RGDP Unemploym. PCE PCE-Core
2013 2.6 (1.5) 7.4 (6.7) 1.5 (1.4) 1.6 (1.5)
2014 3.2 (2.4) 6.9 (5.6) 1.8 (1.4) 1.9 (1.5)
2015 3.4 (?) 6.3 (?) 1.9 (?) 2.0 (?)


  RGDP Unemploym. PCE PCE-Core
2014 2.9 (2.4) 6.2 (5.6) 1.7 (1.4) 1.5 (1.5)
2015 3.1 (?) 5.8 (?) 1.8 (?) 1.8 (?)
2016 2.8 (?) 5.4 (?) 1.9 (?) 1.8 (?)


RGDP Unemploym. PCE PCE-Core
2015 2.1 5.0 0.4 1.4
2016 2.3 4.8 1.7 1.7
2017 2.2 4.8 1.9 1.9
2018 2.0 4.8 2.0 2.0

Notice how they have been “downgrading” their growth and unemployment forecast over time, but not fast enough to catch up with “reality”. Notice how their inflation forecasts will always move towards the target. They must be greatly frustrated!

I certainly wouldn´t bet the house on the model´s robustness (or precision)!

Please, give the Fed a timeless rule

In an interesting post “A kink in the Phillips curve”, Nick Bunker finishes off:

The graph shows the relationship between wage growth for production and non-supervisory workers, and the employment rate for prime-age workers six months prior. It clearly shows that when the labor market is tighter (when the employment rate is higher), wage growth is stronger.

Time Invariant Rule1

In other words, the underlying idea of the wage Phillips curve still stands. It’s just a matter of using measures that fit the time.

As Matt Phillips (no relation to William presumably) points out in his Quartz piece on the curve, the labor market has changed quite a bit since the mid-1970s. He points specifically to the decline in the unionization rate, which is a sign of the decreasing bargaining power of labor in the economy. A 5 percent unemployment rate when labor is relatively much stronger, for example, is very different from a 5 percent unemployment rate when labor is on the back of its heels. Changes in the labor market might be a reason why increases in wages and salaries don’t pass through to overall inflation as much as we might have thought. Back when labor had more bargaining power, wage hikes would bite more into profits and therefore spur companies to raise prices. Now companies have more of a cushion, so a similar wage increase won’t necessarily lead to as strong of a price increase.

Context appears to very much matter. Policymakers will always need to create rules of thumb to help them make sense of an incredibly complex economy. But those rules need to be updated as the world changes.

That´s all very nice, but is it useful? In other words, can´t we come up with a “rule of thumb” that is “timeless”?

The NGDP-LT growth rule may qualify. In the chart below, I use the same graphic strategy, but instead of charting wage growth and the prime-age employment population ratio, I substitute wage growth for NGDP growth.

Time Invariant Rule2

It appears that what´s driving both the employment ratio and wage growth is NGDP growth. While during the “Great Moderation” (“GM”), NGDP growth evolved along a stable level path, by letting NGDP growth crash in 2008-09, the Fed afterwards put it on a lower path, which is why I name it the “False GM”.

The coincidence of the fall in the employment ratio to the crash in NGDP growth makes the argument that the fall in the employment ratio is mostly due to structural/demographic factors hard to swallow.

In his post, Nick Bunker says “but those rules need to be updated as the world changes”. He´s referring to adopting a modified Phillips Curve (PC) concept. Unfortunately, that likely won´t help. Over the last 50 years, no relation has been more modified, refined and specified than the PC, and it still doesn´t work!

As I argued in another post, it is time to abandon “estimation” and do some “experimentation”. The chart gives a clear pointer: try putting NGDP growth on a higher path. The result will likely be a higher labor force participation and higher wage growth. If it is done right, inflation getting “out of hand” shouldn´t be a worry!

The chart below shows how the Fed was successful in bringing the NGDP growth path down to conquer inflation and reap the Great Moderation. Now it has to do the opposite and make the red band look more like the green band!

Time Invariant Rule

If your premise is wrong, it´s no use hiding it underneath reams of papers, footnotes and citations

Yellen on Inflation Dynamics and Monetary Policy:

Ms. Yellen made her case like a prosecutor making a courtroom closing argument. She presented it in a 40-page speech at the University of Massachusetts in Amherst, including 40 academic citations, 34 footnotes, nine graphs and an appendix.

Central to her argument was a belief that slack in the economy has diminished to a point where inflation pressures should start to gradually build in the coming years.

Why should that be?

Those pressures aren’t asserting themselves yet, she argued, because a strong dollar and falling oil and import prices are placing temporary downward pressure on consumer prices. As those headwinds diminish, she predicted, inflation will gradually rise. The Fed needs to get in front of this, she said, and also prevent speculative forces in financial markets that could lead to “inappropriate risk-taking that might undermine financial stability.”

What she´s doing is prosecuting the people!

If she only for a minute thought outside her “Phillips Curve Box”, she would be free to entertain the hypothesis that the Fed´s tightening that has been going on for more than one year is the major force behind the fall in oil prices, commodities in general and the strengthening dollar!

Let´s just wait for the formal crowning of the “biggest mistake of the year”.

Note: I think another “postponement” will happen!