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Do Fed Forecast Errors Matter?

Listed author(s):
  • Pao-Lin Tien

    ()

    (Department of Economics, Wesleyan University)

  • Tara M. Sinclair

    ()

    (The George Washington University)

  • Edward N. Gamber

    ()

    (Congressional Budget Office)

There is a large literature evaluating forecasts by testing the rationality of forecasts and measuring the size of forecast errors, but we know little about the impact of forecast errors on economic outcomes. This paper constructs a measure of a forecast error shock for the Federal Reserve based on the assumption that the Fed follows a forward-looking Taylor rule. Given the effort the Fed puts towards producing forecasts that do not have an endogenous error component, this forecast error shock should be comparable to traditional monetary policy shocks and thus can be used to measure the impact of the Fed’s forecast errors on the U.S. economy. We follow Romer and Romer (2004) and investigate the effect of the forecast error shock on output and price movements. Our results suggest that although the magnitude of the forecast error shock is large, the impact of our shock on the macroeconomy is quite small. The impact is somewhat larger when we take into consideration the Fed’s inability to forecast recessions. The maximum impact across all potential models suggests a decline of approximately one percent of real GDP and two percent of GDP deflator in response to a one standard deviation contractionary forecast error shock.

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File URL: http://repec.wesleyan.edu/pdf/ptien/2015004_tien.pdf
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Paper provided by Wesleyan University, Department of Economics in its series Wesleyan Economics Working Papers with number 2015-004.

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Length: 40 pages
Date of creation: Nov 2015
Handle: RePEc:wes:weswpa:2015-004
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