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Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious?

  • Carlos Capistrán-Carmona

This paper documents that inflation forecasts of the Federal Reserve systematically under-predicted inflation before Volker's appointment as Chairman and systematically over-predicted it afterward. It also documents that, under quadratic loss, commercial forecasts have information not contained in the forecasts of the Federal Reserve. It demonstrates that this evidence leads to a rejection of the joint hypothesis that the Federal Reserve has rational expectations and quadratic loss. To investigate the causes of this failure, this paper uses moment conditions derived from a model of an inflation targeting central bank to back out the loss function implied by the forecasts of the Federal Reserve. It finds that the cost of having inflation above the target was larger than the cost of having inflation below it for the post-Volker Federal Reserve, and that the opposite was true for the pre-Volker era. Once these asymmetries are taken into account, the Federal Reserve is found to be rational and to efficiently incorporate the information contained in forecasts from the Survey of Professional Forecasters

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 127.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:127
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