Friday, March 25, 2016

Central Bank Forecasts: What's in a Dot?

There has been some discussion of central bank forecasts and policy projections, including some blog posts by Tony Yates, Tony Yates part II, Narayana, David Andolfatto, and an editorial on Bloomberg.

The FOMC's dot plots are part of the economic projection materials published four times per year after the March, June, September, and December FOMC meetings. Many central banks in the world publish forecasts. For example, several times a year, the Bank of England publishes detailed forecasts in its Inflation Report. As far as I can tell, the Bank does not offer a projection of its policy rate, though it reports a market-based forecast of the policy rate. The Swedish Riksbank publishes forecasts, and also prominently displays a projection of its policy rate at the top of its home page, as a fan chart. The Bank of Canada offers inflation projections, but does not project its policy rate.

What's the value of a central bank's forecasts? For the most part, the central bank does not have any important information you don't have, that would be relevant for a macroeconomic forecast. Nor does the central bank possess any special knowledge about how to conduct macroeconomic forecasts. Basically, any professional forecasting firm should be able to do it as well or better. So, we're not interested in a central bank's forecasts because these are good forecasts. But perhaps we care about the central bank's forecasts because this tells us something about what the central bank will do. For example, the central bank could be pessimistic, and wrong, but I pay attention because monetary policy matters for my decisions. I'm better off if I know about the pessimistic central bank forecast than if I did not know.

There are aspects of central bank forecasting that are very different from private forecasting, however. For example, the Bank of England, the Swedish Riksbank, and the Bank of Canada all target inflation at 2%, and they provide forecasts of inflation, which is the thing they are trying to control. Thus, implicit in the central bank's forecast is a policy exercise. The ultimate forecast is conditioned on a particular path for policy instruments, and the process by which that policy path was chosen involved alternative policy simulations - which would produce different forecasts. If monetary policy really matters to me, I would want to know a lot about that process. Indeed, I would like to know the path for policy instruments that underlies the forecast, the whole structure of the model that was used to generate the forecasts, and the add factors that were applied to the model to produce the forecast (trust me, the add factors are really important). But most central banks are too secretive to give me all that stuff (that's "me" as if I were you).

So what about the dot plots? In principle, this provides some of the information that people affected in important ways by monetary policy are looking for. Narayana gives a good description here of how the dot plots are constructed. Each dot represents what an individual FOMC member thinks the optimal policy rate would be at the end of each future calendar year, given his or her forecast of other macroeconomic variables. That's important. This is not an individual's forecast of what the FOMC will actually do, it's what the individual thinks he or she would do in the future if the world evolves in the way he or she thinks it will, and if he or she has ultimate decision-making power. Of course there's a lot the dot plots don't tell you. Which dot is who? Maybe that dot doesn't get to vote this year? What's the forecast of other variables associated with each dot? What's the model (if any) that was used to evaluate policy? It would be nice to know which dots are associated with who, so that I could at least know who to ask which questions.

Let's look at some dot plot examples (all from the Board's web site). Here's one from January 2012:
So, in January 2012, of 17 FOMC members, 3 think liftoff should happen by the end of 2012, 6 by the end of 2013, and 11 by the end of 2014. And in the long run, they're collectively thinking that the policy rate will be above 4%. So, what actually happened (liftoff in December 2015) appears delayed relative to that projection. But so what? Maybe the economy evolved in ways that these FOMC participants did not anticipate? Let's look at another one. This is for March 2014:
So you can see, comparing this chart to the last, that the committee's views have changed in two years' time. In 2012, they thought they would be lifting off by the end of 2014, but in March 2014 all but one are convinced that liftoff by December 2014 is off the table. For 2014 and 2015, the March 2014 projection is consistent with what actually happened - no liftoff in 2014, and liftoff by December 2015 (just barely). But, in March 2014, FOMC participants were predicting a policy rate that, on average, was above 2% by the end of 2016. That appears to be unlikely now.

Finally, this is the dot plot for September 2015:
This shows how liberally the projection exercise can be interpreted by the participants. Note the outlier - one participant thought it would be optimal to have a negative policy rate, at least until the end of 2016. As Janet Yellen pointed out in Congressional testimony in February, she is not entirely clear that negative interest rates on reserves are even feasible in the United States, given both the legalities and our institutional structure. So, if one were to say, in September 2015, that negative interest rates would be optimal in December of 2015, and in December of 2016, it's not clear what that means, as the feasibility of such a policy still appears unsettled.

Some people are worried that the dot plots might be interpreted as commitments. If they were interpreted this way, that would be bad. The September 2015 dot plot above, interpreted as a commitment, says the FOMC was committing in September 2015 to roughly five quarter-point rate hikes by the end of 2016. If so, we would say they were failing. But that's not the right interpretation. What we should be doing is asking what has happened since September 2016 to change FOMC participants' views, how those views have changed, and whether that makes any sense. And the dot plots help you make that assessment, though maybe they don't tell you everything you want to know.

The Bloomberg editorial suggests the dot plots should go: would help more to stop releasing information that begs to be misunderstood as a commitment to a specific path for interest rates, when the Fed is making no such commitment.
By this logic, I think, saying anything at all means you are "begging to be misunderstood." By now, I think the dot plots have helped people understand what the FOMC's policy statements mean. For example, the information in fed funds futures has typically predicted a lower policy rate trajectory for some time than what is in the dot plots - and typically the market has been right.

Narayana has some other suggestions about forecasts. From the Bloomberg editorial:
...Narayana Kocherlakota offered two other suggestions. First, delay publication of the dot plot to coincide with release of the Fed minutes: That way, it would be seen in the context of the Fed's internal debate on policy, rather than as part of its collective judgment on interest rates. Second, release a collective medium-term forecast of output and employment, modeled on the Bank of England's so-called fan charts.
The first suggestion would seem to make us worse off. This delays useful information, which is costly, and there is not much benefit to be had. The information in the minutes is only an outline of the FOMC discussion, and there is little to connect with information in the dot plots - hard to connect the dots, basically, even given the minutes. Second, a "collective medium-term forecast..." by all FOMC participants is not feasible, given the decentralized structure of the Federal Reserve System. So much for that.


  1. Interesting article. If there is massive demand for long bonds, and there is massive demand for long bonds as collateral in the derivatives markets, isn't raising the short rate a bit futile? Doesn't demand for bonds trump (not Trump, lol)any efforts on the part of the Fed? If nothing much raises yield for the long term due to all this demand for bonds, wouldn't it be better to forbid the usage of the long bonds in derivatives markets? Otherwise we are stuck in low yield forever. Am I missing something about this view?

  2. The one lesson we can take from the FOMC "predictions" is that they are worthless.

    1. As I tried to make clear, these aren't predictions. But, if the future unfolds as the committee thinks it will, then the dot plots should be a good forecast of future policy. If the future unfolds the way the committee thinks it will, but previous dot plots are inconsistent with what the committee is doing currently, then that tells you something. So, a bad prediction is actually valuable information.

  3. I hear what you are saying but what is particularly galling is the fact that some of the FOMC members thought we would be above 2 percent in 2014 despite knowing the harsh austerity post 2010 and the huge slack in the labor market. Also, the prediction in Sept 2015 is for 3 percent in 2018! Only if Bernie is elected and the Republicans don't control congress.

    1. So, you would say that, say, the policy rate path in the first chart, particularly the more hawkish dots, was inappropriate, given what we knew in January 2012. Of course there are six people who were saying they expected the policy rate in 2014 to be 0.25%, as of Jan. 2012. I'm guessing you think that was a good policy. To put words in the mouths of the more hawkish FOMC types, they probably were saying that the financial crisis was long gone, the labor market was rapidly tightening and, in anticipation of the economy returning to normal, the Fed should start returning to normal. That's a coherent argument, which you could base on sound economics. Not sure why you should find it galling.

    2. It's only a coherent argument if the inputs are correct - that is what I find particularly galling. Back in 2012 we knew they were wrong:
      1. Financial Crisis was long gone but not the hangover of debt to consumers. The mortgage delinquency rate was about 10 percent and had been for 3 years! The norm is about 1 percent - it's still at 5.
      2. The labor market was not rapidly tightening. Even if we take the experience of the previous decade and the 2001 recession the recovery was very anemic and the EFF didn't hit 2 percent until unemployment was down to 5.3 percent. In 2012 the unemployment rate was 8.3 percent at a 1 percent per year reduction that would have put us at 6.3 in 2014. Additionally, to get a better idea of slack one should look at the employment to population ration and that was about 4 percent below what it was in 2005. There was huge slack in the employment market in 2012, there is STILL slack in 2016 - the employment to population ratio is 3.5 percent down from the peak in Dec 2006.
      3. The economy was not returning to normal any time soon.

    3. 1. I'm assuming you think that more inflation is a form of debt relief. But continued ZIRP (zero interest rate policy) actually makes inflation low.
      2. Here, the critical question is whether epop is an appropriate measure of slack. Put another way, why would labor force participation fall for an extended period while unemployment was falling at a high rate? Seems you can make a strong case that epop is low because of long-run factors that monetary policy cannot or should not do anything about. So maybe not so galling.
      3. This may just be the new normal: 2% real GDP growth per year and low epop. There may be an inefficiency but, again, nothing that monetary policy is equipped to deal with.

    4. 1. I do think that inflation is a form of debt relief however, that is beside the point here. If consumer confidence and spending are suppressed then the economy will suffer, the economy is largely based around consumer spending.
      2. The historical record does not show that EPOP was falling as unemployment was falling. What it shows is that EPOP fell drastically because of the recession and bottomed out. Then it has very slowly recovered over the next 6 years. The unemployment rate has recovered over the last 6 years however, there is still a large shortfall of people who are employed this will continue to suppress wages and thus inflation.
      3. Finally something where we agree! Monetary policy will not be able to fix this but increasing rates will not make the situation better, in fact it will make it much worse.

    5. "does not show that EPOP was falling as unemployment was falling"

      not epop, participation rate.

      "Monetary policy will not be able to fix this but increasing rates will not make the situation better, in fact it will make it much worse."

      The idea is that the Fed can't hit a 2% inflation target if rates stay low. They will continue to undershoot. I know this doesn't make sense if you have a Phillips curve view of the world.

    6. Both EPOP and participation indicates the high level of slack in the economy right now. We know that the unemployment rate hides the real story about the labor market because it is comprised of the participation rate divided by the EPOP both of which are required to get a real grip on what is happening. If we just examine 25-54 year olds we see that both participation rate and EPOP are at levels last seen in the mid 80s. We have not even caught up with the levels at the bottom of the early 90s recession. Just to get a handle on this the last time the fed funds rate was 1 percent (in 2003) the participation rate was 2 percent higher and the EPOP was 1 percent higher. That combined 3 percent is still labor that can easily be enticed into the labor market if jobs are available without undue inflationary pressures. To get to 3 percent EFFR would take even more and to think that this will occur in 2 years is dreamland. I hope those political conditions occur but I am extremely skeptical.

    7. "...labor that can easily be enticed into the labor market if jobs are available without undue inflationary pressures."

      You can measure job availability:

    8. Again that raw job openings "rate" tells you nothing unless it is interpreted within the context of the job market. What you really should be looking at is the JOLTS. The latest data shows that the openings are at 5.5 million, hires are at 5 million and separations at 4.9 million that is only a difference of about 0.5 million net new additional jobs available in the market (less than 0.5 percent of the 25-54 year old cohort). Also, that number doesn't indicate what quality those jobs are and it they are of high enough quality to entice people back into the market.

    9. "you really should be looking at is the JOLTS..."

      That is from JOLTS.

      "what quality those jobs are and it they are of high enough quality to entice people back into the market."

      So, again, you're imagining some inefficiency that monetary policy can correct? You want the Fed to somehow manipulate the quality of jobs out there?

    10. "So, again, you're imagining some inefficiency that monetary policy can correct? You want the Fed to somehow manipulate the quality of jobs out there?"

      What are you talking about? The discussion is about the FOMC and their propensity to be ridiculously optimistic about the future economy.

    11. You brought up the issue of labor market "slack." You seemed to think there is a lot of it. I was trying to figure out whether you had some insight into this, or if you're just confused.

    12. @ Pinkybum: Good luck arguing with freshwater "economists" who put quotations marks around facts. :D

  4. Kocherlakota was probably making the negative dots. He also is for a lot of fiscal spending and creation of more treasury bonds. But I wonder if even that would cause rates for long bonds to rise. I mentioned you in the article, Prof Williamson. I hope I got it right.