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16-09-2019

Appropriate monetary policy and forecast disagreement at the FOMC

Author: Guido Schultefrankenfeld

Published in: Empirical Economics | Issue 1/2020

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Abstract

I study the forecast updating behavior of Federal Open Market Committee members to assess how individual views on appropriate monetary policy translate into disagreement about the macroeconomic outlook. I match the cross-sectional skewness in interest rates with its inflation and unemployment forecast counterparts and apply standard panel techniques to the data. I observe that hawkish minority voters tend to forecast higher inflation rates relative to the consensus view on the future economy. A higher degree of skewness in the individual inflation forecasts can be attributed mainly to regional Federal Reserve presidents’ minority views on appropriate policy. When investigating potential forecast exaggeration due to strategic motives, however, I find significant differences in the forecast updating behavior neither for Fed governors as opposed to regional Fed presidents nor for members voting with the majority as opposed to voting against the majority nor for stayers and switchers with respect to individual monetary policy stance.

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Theoretical discussions of interest rate assumptions relevant for central banks can be found, inter alia, in Galí (2011), Svensson (2006) and Woodford (2005).

In a certain sense, by submitting an individual forecast that is different from the consensus view, the member is expecting a higher forecast error for the consensus forecast than for his or her forecast, and the deviations of the individual forecast from consensus could be interpreted as a prediction of the consensus forecast’s forecast error. Related to this, Chong and Hendry (1986) provide a discussion on the monotonicity of forecast variances.

The observed pattern in average forecast dispersion could also be interpreted such that forecast dispersion can be a misleading proxy for forecast uncertainty. See, for instance, Zarnowitz and Lambros (1987) and Lahiri and Sheng (2010).

“Appropriateness” has always been an integral part of the FOMC’s language. However, more recent FOMC minutes, for instance, of December 13 and 14, 2016, provide a fairly clear-cut definition where “appropriate monetary policy is defined as the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the Federal Reserve’s objectives of maximum employment and stable prices.” See https://www.federalreserve.gov/monetarypolicy/fomcminutes20160615ep.htm.

The line of thought actually abstracts from the discrete nature of the fed funds rate, where increments and decrements usually come in 25 basis point steps, as described, for instance, in Dueker (1999) or Gerlach-Kristen (2004). However, for the empirical exercises in this study, as is to be seen below, this discreteness will not be an issue.

The voting takes place at meetings, and “The FOMC holds eight regularly scheduled meetings during the year, and other meetings as needed.” The sample thus includes extra dates from the FOMC calendar, if relevant.

If the preferred basis point change in the dissenter is not explicitly stated, I assume it to be 25 basis points. Exemplarily, consider the period from March 31 to July 1 of 1998, when Jerry L. Jordan of the Cleveland Fed dissented in three consecutive meetings. His reasoning suggested an interest rate increase, but the desired amount of increase remained unknown.

See the Fed’s FOMC background information under http://www.federalreserve.gov/monetarypolicy/default.htm.

See also Chappell Jr. et al. (1993, 2004, 2007a, b) and Chappell Jr. and McGregor (2000) for alternative approaches of generating individual interest rate series.

A detailed data set of FOMC members’ forecasts with member names attributed is compiled and described in Romer (2010). The data set is updated using individual-level FOMC data published with a lag of ten years, available at http://www.phil.frb.org/research-and-data/real-time-center/monetary-policy-projections/.

The FOMC used to forecast inflation as measured by the consumer price index CPI. With the Monetary Policy Report of February 17, 2000, the FOMC started to emphasize the use of the index for personal consumption expenditures PCE to measure inflation. See the Board of Governors’ Monetary Policy Report of February 2000 on p. 4.

“Beginning with the October 30–31, 2007 FOMC meeting, FOMC meeting participants [...] submit individual economic projections in conjunction with four FOMC meetings a year.”, as stated under http://www.federalreserve.gov/monetarypolicy/fomc_historical.htm.

Both “central tendency” and “range” are actually range measures, where “The central tendency excludes the three highest and three lowest projections for each variable in each year.”, as described, for instance, in the Fed’s February 2013 Monetary Policy Report on p. 43. However, there are exceptions where the central tendency is indeed represented by a single number.

The monetary policy objectives are described by the Federal Reserve Act amended in 1977. See, for instance, https://www.federalreserve.gov/aboutthefed/section2a.htm.

The notation corresponds to the quarterly frequency of the forecast horizon. See Orphanides and Wieland (2008) for a similar notation.

Hence, the panels are unbalanced. The cross-sectional dimension in each panel is determined by matching the forecasts with the interest rate voting data, as explained in the following.

Whether individual inflation and unemployment rate forecasts themselves are modal values is subject to discussion, see Reifschneider and Tulip (2007, p. 12) on the “modal nature of projections.”

In the rare case of bi- or multimodality, I select the mode closest to the median.

See McCracken (2010b) for a description of absolute deviations from the median as a disagreement measure for FOMC forecasts.

As mentioned before, interest rate skew is different from zero in roughly \(17\%\) (\(11\%\)) of the cases for \(h=1\) and \(h=5\) (\(h=3\)).

Due to the changing composition of the FOMC during the half-year collection period before the respective semi-annual forecasting round, there are \(M_{t}\) observations of \(\mathrm {iskew}_{m,t}\) per period t. Matching forecast disagreement for horizon \(h=3\) and interest rate disagreement from the \(M_{t} \in [9;15]\) members participating in February forecasting yields an unbalanced panel data set of \(N=191\) observations. July forecasting for horizons \(h=1\) and \(h=5\) with \(M_{t} \in [9;11]\) yields 139 observations.

Due to the Prais–Winsten transformation used with the GLS estimation procedure, the coefficient estimates are only expected to be qualitatively similar.

See Clements (2015) for a thorough discussion of the test’s properties.

See http://www.federalreservehistory.org/people for further background information on the Fed’s FOMC members.

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Title: Appropriate monetary policy and forecast disagreement at the FOMC
Author: Guido Schultefrankenfeld
Publication date: 16-09-2019
Publisher: Springer Berlin Heidelberg
Published in: Empirical Economics / Issue 1/2020
Print ISSN: 0377-7332
Electronic ISSN: 1435-8921
DOI: https://doi.org/10.1007/s00181-019-01755-9

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