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A simple proposal to improve fed forecasting and policy making

The Wall Street Journal has undertaken a very interesting task – the newspaper has evaluated the forecasting skills of different FOMC members.

This is from the Journal:

The Wall Street Journal examined more than 700 predictions made between 2009 and 2012 in speeches and congressional testimony by 14 Fed policy makers—and scored the predictions on growth, jobs and inflation.

Review the WSJ analysis and the actual forecasts of Fed officials.The most accurate forecasts overall came from Ms. Yellen, now the Fed’s vice chair. She was joined in the high scores by other Fed “doves,” policy makers who wanted aggressively easy money policies to confront a weak U.S. economy and low inflation. Collectively, they supported Fed Chairmen Ben Bernanke‘s strategy to pump money into the U.S. economy.The least accurate forecasts came from central bank “hawks,” those who feared Fed policies would trigger rising inflation.

A lot of attention has been given to the fact that the “doves” have been much better in their forecasts of inflation, growth and the labour market situation than the “hawks” on the FOMC. However, this is not really what I find interesting about the WSJ analysis. The interesting point is rather to what extent FOMC’s members statements and forecasts are biased in one or the other direction.

It hence, look like each FOMC member is suffering seriously from cognitive dissonance as the will try to find “evidence” for their initial biased views on the US economy. Furthermore, it is clear that FOMC members are engaged in a signaling process. They want to signal to the outside world that they are either doves or hawks. As a result doves underestimates inflation risks, while hawks will tend to overestimate inflation risks.

I should stress that I don’t think that the doves are in generally and consistently better at forecasting. Rather their biases have just worked better this time around. In the 1970s the hawks would probably have done a better job on forecasting than the doves.

Political forecasting versus market forecasting

In his very impressive book “Expert Political Judgment:How Good Is It? How Can We Know” Philip E. Tetlock examined the forecasts of “experts” in different areas. Tetlock concluded that there are two kind of forecasters – foxes and the hedgehogs. Tetlock argues that the  fox — the non-ideological and middle of the road forecaster who draws from an eclectic array of sources and traditions – in general is a much better forecaster than the hedgehog, who “knows one big thing, toils devotedly within one tradition, and imposes formulaic solutions on ill-defined problems.”

In my view most FOMC members are hedgehogs and the reason is that they have little incentive to actually be right on their forecasts. Rather they have a strong incentive to signal that they belong to a certain (political) grouping.

This is a well-known problem from all “political forecasting”. I myself used to do macroeconomic forecasting when I worked for the Danish government many years ago and it will be no big surprise to anybody when I say that the macroeconomic we where doing at that was hugely biased in a certain direction and for obvious reasons. After all it only makes sense that a government’s economists will forecast that the government will be successful in hitting their policy targets.

On the other hand during my work in the financial sector I have come to realize that there is little room for biased forecasts. I will simply be punished by the markets if my forecasts are hugely biased and consistently too positive or too negative. The clients I interact with in my daily job in the financial sector simply want the best and most accurate forecasts to be able to make the best investment decisions. That gives me a significant incentive to moderate my strong personal hedgehog tendencies.

The FOMC members do not have such incentives and as a result their forecasts tend to be hugely biased in either direction and as a result so will monetary policy decisions be.

Provide FOMC members with the right incentives

The FOMC members are biased because they got the wrong incentives and the only way to solve this problems is to change their incentives. My solution is quite simple – simply weigh FOMC members’ votes based on forecasting accuracy.

It could be done fairly easily. Every month every FOMC member will be asked for their forecasts for real GDP growth, nominal GDP, PCE core inflation and unemployment one-year ahead. Then one year from now they forecasts will be evaluated. Those members who are above average forecasters will become “super voters” on the FOMC an their votes will count more than the bad forecasters on the FOMC. You could also make salaries dependent on forecasting accuracy.

I certainly do not think that there are people who are in general better forecasters than others or even that better forecasters are better policy makers. Rather the purpose of my proposal is to remove biases in fed forecasting and fed policy making.

Do you really think that for example Plosser consistently would make biased forecasts if it was published how bad a forecaster he is an that he is consistently biased? And would he have a strong incentive to try to get his forecasts right if he was punished if he made bad forecasts?

The easiest thing was of course to set up a prediction market instead to provide forecasts and commit the FOMC to vote on fed policy based on these forecasts. In fact both could be done. If there was a prediction markets the market forecasts could be compared with the individual FOMC members’ forecasts. That would also provide an incentive for FOMC members to be less biased in their forecasts.

Obviously better forecasts do not necessarily mean better policy decision. However, I believe it is likely that the incentives to provide better forecasts also would influence the FOMC members to voter in a less politicized fashion and that would ensure a better policy outcome. After all it would be pretty hard for a “hawk” to vote for a rate hike if he was forecasting low inflation, weak growth and high unemployment without revealing him or herself as a biased partisan rather than a serious policy maker.

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1 Comment

  1. Alex Salter

     /  July 30, 2013

    Give every FOMC voter (and Member of Congress) a pension indexed to per capita RGDP ten years to the day they take office.

    Reply

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