The Evolution of Uncertainty and Risk around the FOMC’s Macroeconomic Forecasts: Back to Normal
Over time, the Federal Reserve's Federal Open Market Committee (FOMC) has increased the information it provides to the public about its forecasts for economic conditions in the future. In 2007, the FOMC introduced the Summary of Economic Projections (SEP), which reports FOMC participants’ projections for real GDP growth, the unemployment rate, PCE inflation, and core PCE inflation. The forecasts are made conditional on each participant’s view of appropriate monetary policy. Beginning in 2012, the SEP was expanded to include projections for the federal funds rate.
In June 2011, the FOMC began reporting by including participants’ assessments of uncertainty around their projections and the perceived distribution of risk for each of the projected variables. All participants are asked to provide their opinion on whether the amount of uncertainty around their projections is higher, lower, or in line with the historical error ranges. For comparison, the historical error ranges reported in the SEP are essentially the average absolute errors made by private and government forecasters over the last 20 years. In addition, FOMC participants are asked whether the risks to the economy are more likely to cause their projections to miss above or below the actual outcome or are broadly balanced.
Generally, the forecast uncertainty associated with macroeconomic variables such as real GDP growth is correlated with the overall macroeconomic conditions prevailing in the economy. A higher than usual uncertainty around the projections of economic growth is typically associated with a weak economy. Arguably, highly uncertain economic conditions may also contribute to slower economic growth.
The information on uncertainty now reported in the SEP helps to give the public a much more complete picture of the FOMC participants’ assessment of overall macroeconomic conditions. While the FOMC’s projections of macroeconomic variables are often taken as the participants’ views on current and likely future macroeconomic conditions, it is the combination of projections and the forecast uncertainty around them that gives the complete picture.
From June 2011 through at least the end of 2012, most participants reported uncertainty to be higher than usual around all of their projections. But since then, it has gradually declined back to normal levels. Currently, most participants believe that uncertainty around their projections for economic growth, the unemployment rate, and inflation is similar to historical averages, and the risks around those projections are broadly balanced.
As of the March 2014 FOMC meeting, almost all of the participants (14 out of 16) believed that the amount of uncertainty around their projections for economic growth (real GDP growth) was similar to the historical average of the past two decades. The total number of participants reporting normal uncertainty was the highest it has been since the SEP started reporting this measure. The remaining two participants believed uncertainty is higher than normal. In contrast, in December 2012 it was quite the opposite, when only one participant believed the amount of uncertainty at the time was similar to normal, and the rest of the participants (18 out of 19) reported higher-than-normal uncertainty.
It is worth pointing out that the majority of participants continued to report higher uncertainty from June 2011 until mid-2013, a period characterized by many as a disappointingly slow recovery from the Great Recession. Since then, as various headwinds to the economy have subsided, including those from fiscal policies, the reported uncertainty has gradually shifted toward more normal levels.
In line with the evolution of real GDP uncertainty, most participants (14 out of 16) have come to view the balance of risks to economic growth as being broadly balanced as of the latest SEP—that is, they thought it was equally likely that a positive or negative shock would affect economic growth. This is the largest number of participants who have reported the risks to economic growth as being balanced in the past three years. Just over a year ago, a majority of the participants viewed risks as being weighted to the downside, meaning they saw a higher likelihood for realized economic growth to turn out below their projections than above. So in line with a sharp shift in uncertainty toward normal levels, a significant shift to more balanced risk perceptions among the majority of participants has occurred.
The evolution of uncertainty around the projections of the unemployment rate has been very similar to that of real GDP. As of the March 2014 meeting, a majority of participants (14 out of 16) believed that uncertainty about unemployment was comparable to its levels of the past 20 years. This is the highest this reading has been since the SEP started reporting this measure. All of the 16 FOMC participants at that meeting viewed risks to the unemployment rate as being broadly balanced. Risks in 2011, by contrast, were viewed as being weighted to the upside by most participants a little over a year ago, meaning that given the level of uncertainty, they saw the balance of economic risks as creating conditions in which unemployment would more likely exceed expectations. In addition, a majority of the participants at the time reported higher than normal uncertainty. So along with a sharp shift in uncertainty about the unemployment rate toward normal levels, a significant shift in the risk perception toward more normal levels has also occurred among the majority of participants in the last three years.
It is notable that none of the FOMC participants has reported the uncertainty for economic growth and unemployment to be lower than normal over the past three years. Additionally, no participant has classified the risks to his or her economic growth projections as being skewed to the upside—and only a few reported risks as being skewed to the downside for the unemployment rate. One possible explanation for this tendency is that the FOMC’s main policy tool, the federal funds rate, has been set at its effective lower bound over this time, complicating the job of the FOMC in combating adverse shocks to the economy. Another explanation is that it reflects the general difficulty in forecasting these variables after being hit with the deepest recession since the Great Depression, which has brought many conventional macroeconomic relationships into question.
The uncertainty around the FOMC’s projections for both PCE inflation and core PCE inflation (PCE inflation excluding food and energy), like the uncertainty around real GDP and unemployment rate forecasts, has also trended back to normal. According to the June 2011 SEP, most participants (14 out of 17) reported uncertainty around their PCE inflation forecasts as being higher than the average of the past two decades. Since then it has gradually shifted toward normal levels.
According to the most recent SEP, a majority of FOMC participants viewed uncertainty around their inflation projections as normal. Only three participants believed uncertainty to be higher than normal, and two viewed it to be lower. The trends related to the perceived distribution of the risks around the inflation projections are somewhat different from real GDP and the unemployment rate, however. Over the last three years, a majority of the FOMC participants continued to believe that risks around their inflation projections were equally balanced. In other words, they saw equally likely probabilities that positive or negative shocks could affect inflation. That being said, since mid-2012 the number of participants reporting risks as being weighted to the downside has been trending up, reflecting the fact that inflation persistently came in below the participants’ median projection.
Over the last year or so, as various headwinds to economic growth have subsided and the unemployment rate has fallen, economic conditions have begun to normalize. The same can be said for the forecast uncertainty of FOMC participants, which has fallen back to more normal levels. Normal uncertainty and broadly balanced risks are a welcome sign, because they tend to go hand-in-hand with stable economic conditions.