For release: Feb. 25, 2004

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Implications of Economic Forecast “Surprises” More Important Than Forecasts Themselves: St. Louis Fed’s Poole

Link to speech.

Charlotte, N.C. — Anyone interested in monetary policy should spend less time on economic forecasts and more time on implications of forecast surprises. The true art of good monetary policy is in managing forecast surprises and not in doing the obvious things implied by the baseline forecast.

Those were the key points made by William Poole, president of the Federal Reserve Bank of St. Louis, in a speech today to the Charlotte Economics Club.

Poole said the consensus forecast shows GDP increasing from 4 to 4 and ½ percent from the fourth quarter of 2003 to the fourth quarter of 2004. Inflation measured by the CPI is forecast in the 1 and ½ to 2 percent range and as measured by the GDP chain price index is forecast in the 1 to 1 and ½ percent range over that period. The unemployment rate is forecast to be around 5 and ½ percent by fourth quarter 2004.

Citing a St. Louis Fed study on forecast accuracy, Poole said that for a one-year-ahead forecast, a key measure of forecast error was about 1.4 percentage points. “That leaves a lot of room for surprises,” said Poole. “If for convenience we say that the GDP growth forecast is 4 and ½ percent over the four quarters of 2004, the one standard error leaves us with a forecast band of 3 to 6 percent growth over this period. At three percent, everyone would fear that the recovery is faltering; at 6 percent, most would say we had a boom on our hands.”

Poole added that one standard deviation on either side of the expected value “doesn’t by any means” exhaust the range of possible outcomes. “As a rough approximation,” he said, “one time out of three the one-year-ahead forecast of real output growth will fall outside a range of plus or minus 1.4 percentage points of the stated forecast number.”

Poole said it is easy to criticize forecasts, but extremely difficult to come up with better ones. “Good forecasters produce state-of-the-art forecasts,” he said. “Policymakers must deal with forecast surprises.”

As an example of the difficulty in forecasting economic turning points, Poole cited the recent recession, noting that five months before the recession’s onset, neither the Blue Chip consensus forecast nor the members of the Federal Reserve’s Federal Open Market Committee (FOMC) correctly anticipated it. “Another noteworthy example is the aftermath of 9/11,” said Poole. “After the attacks, forecasters turned bearish on near-term prospects. We now know that in 2001’s fourth quarter the economy rebounded to a 2.1 annual rate of growth in real GDP.”

Poole said that because of the documented uncertainty of economic forecasts, some dismiss them altogether and view them as irrelevant for policy because their errors are large. “To me, that’s completely wrong,” he said. “Instead, policy needs to be informed by the best guesses incorporated in forecasts, and by knowledge of forecast errors. Forecast errors create risk, and that risk needs to be managed as efficiently as possible. The surprises that create forecast errors also created the need for policy changes that can’t be anticipated in advance because the surprises can’t be anticipated.”

Poole said that if, in the FOMC’s judgment a surprise calls for a policy action, the FOMC would be derelict in its responsibilities if it failed to act. “Given the economic shock, the FOMC’s action ought not to be a surprise,” he said. “The real surprise would arise if the FOMC were to do nothing in the face of a shock calling for action.”

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