As part of its ongoing efforts at helping the public understand exactly what its intentions might be, the Federal Reserve today released more detailed minutes of its October 30-31 meeting that included the Fed’s expectations for what comes next.
Evidently each governor and reserve bank president was asked to provide his or her projection, however arrived at, for the numbers that they expect to see for GDP growth and inflation over the next three years. Table 1 in today’s release includes the range of numbers that FOMC meeting participants provided. For example, the most pessimistic participant is expecting 1.6% real GDP growth for the four quarters that will end 2008:Q4, while the most optimistic participant is expecting 2.6% growth.
I was particularly struck by the 3-year projections. GDP growth is a time series with relatively rapid mean reversion, so that one would need a lot of evidence (or courage) before offering a 3-year-ahead forecast that is anything other than the historical average. That historical average is 3.3% if you go all the way back to 1948. Yet even the most optimistic FOMC participant was expecting no more than 2.7% real GDP growth for 2010.
Perhaps some would take a view that productivity and GDP growth rates wander persistently (and predictably), and might prefer to base a forecast on the average over just the last five years. Yet the average 4-quarter GDP growth between 2001:Q4 and 2006:Q4 was 2.7%, the upper limit of the FOMC 3-year-ahead projection. These forecasts imply that we’re going to see a 3-year continuation of last year’s unusually sluggish performance, which I would regard as an a priori unlikely scenario. Even if a full-blown and unusually long recession begins in 2008, a recovery should have begun by 2009:Q4 and we will see much better than 2.7% growth for 2010.
The Fed’s 3-year-ahead inflation forecast also surprises me a little, in that the highest inflation rate that any member anticipates for 2010 is only 2.0%. Inflation is a time series with far less mean reversion than GDP growth, so it’s probably unreasonable to use the long-run historical average inflation rate (3.3%) as your forecast for 2010. But for the FOMC participants unanimously to expect the inflation rate in 2010 to be below its average value of the last five years, and for that matter likely below even its value for 2006, should raise an eyebrow.
So how should we interpret these numbers? The FOMC minutes explain:
Each participant’s projections are based on his or her assessment of appropriate monetary policy.
In other words, the FOMC is saying that, if the Fed (i.e., they themselves) does what they think it should, GDP is going to be growing more slowly and inflation is going to be lower three years from now than a forecast that did not condition on the assumption of such Fed behavior would have anticipated. I believe the spirit of this exercise is to communicate to us that if GDP is growing at 3% in 2010 but inflation is not under 2%, they intend to raise interest rates to bring both down.
For comparison, the 10-year expected CPI inflation implicit in the nominal-TIPS yield spread is over 2.3%. Taken at face value, the Fed is trying to warn us that it intends to be tougher on inflation than markets currently are betting on, and, as I commented last week, the market at the moment appears if anything to be surprisingly confident in the Fed’s ability and commitment to keep inflation low.
Now, that raises the question– If at some point in the future the Fed is going to surprise the market with a more hawkish policy than is currently anticipated, when will that surprise come? One obvious answer– at the coming December 11 FOMC meeting, for which fed funds options and futures presently seem to be betting pretty heavily on seeing another cut in the fed funds target. If the Fed means what it says with these just-released minutes, the market is wrong to assume that the fed funds target will be lowered to 4.25% on December 11.
My reading of these FOMC forecasts appears not to be the common reaction of other analysts, based for example on the failure of today’s fed funds futures prices to re-evaluate the prospects for a December 11 rate cut, and based on the views surveyed at the WSJ, MarketWatch, or Bloomberg. I guess that other people are assuming that the Fed is offering an intentionally pessimistic 3-year forecast for output and intentionally optimistic 3-year forecast for inflation in order to “warn” markets that it’s eventually going to get serious about this inflation thing. Such a scenario reminds me a bit of the mothers I sometimes see in the grocery store with completely wild children whom the mother is constantly admonishing, and thereby accomplishing little more than teaching the child that passionate admonitions from mother mean nothing.
I’m reminded again also of the wisdom of outgoing Federal Reserve Bank of St. Louis President Bill Poole:
The best way to establish credibility is to say what you’re going to do, and then do it.