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Reality Check: Evaluating the Federal Reserve Board

| MoneyRates.com Senior Financial Analyst, CFA
min read

arrows_in_targetEveryone from Wall Street to the White House looks to the Federal Reserve Bank to steer the economy in the right direction.

The question is, How well does it chart the course?

It's an important question to ask. Many consumers make financial decisions based on what kind of economy the Fed sees coming.

To answer that question, MoneyRates.com looks back year by year to see how the Fed's economic projections for that year turn out. It's a reality check of sorts that's been done now for several years.

And it turns out that, when it comes to navigating economic waters, the Fed has a mixed record. Sometimes it knows exactly where it's going, and other times it seems adrift.

How Accurate is the Fed?

Generally speaking, the Fed's outlook has been fairly close to the mark.

Last year, though, the Fed missed by a record amount on one forecast - and in a pretty embarrassing category to get wrong. The Fed proved to be particularly wrong about the federal funds rate, something the Fed's own Federal Open Market Committee (FOMC) sets.

It's not terribly surprising that the Fed should turn out to be wrong when it comes to predicting the federal funds rate. It's one economic variable that, over time, the Fed has been most wrong about.

The thing is, it was especially far off about 2019.

Four times a year, as part of its meetings that decide the fed funds rate, the FOMC releases a set of economic projections for the next few years. And since 2014, those projections have included where the fed funds rate would end up.

The other variables in the FOMC economic projections are GDP growth, the unemployment rate and inflation. MoneyRates.com looked at each of the Fed's year-end projections since 2014 and compared those projections with how the data actually turned out in the year that followed.

The following table summarizes how accurate the Fed's predictions have been over the five years studied:

Accuracy of Federal Reserve Economic Projections for the Next 12 Months Over the Past Five Years
Economic IndicatorAverage Discrepancy
GDP0.32%
Unemployment Rate0.13%
PCE Inflation0.50%
Fed Funds Rate0.635%

Feedback Loop: Economic Indicators and the Federal Reserve

The Fed's projections are important because economic conditions and the Fed's decisions are a feedback loop where each affects the other. The Fed reads economic conditions and makes decisions accordingly. Those decisions, in turn, impact economic conditions. The Fed must then adjust to changing conditions, and so on.

Anatomy of an FOMC decision

The two mandates the Fed references regularly are to keep unemployment low and inflation under control (currently, that means close to a target of 2 percent a year). So, the Fed closely monitors the unemployment rate and this is one of a handful of economic indicators for which the Fed makes regular forecasts.

When it comes to inflation, the indicator the Fed uses is the Personal Consumption Expenditure (PCE) Price Index. It also includes this in its regular forecasts. The PCE Price Index reflects similar price trends to the more widely known Consumer Price Index (CPI), but its methodology differs in a number of respects. For example, the CPI focuses on out-of-pocket costs to consumers while the PCE Price Index includes indirect costs such as health insurance employers pay for on behalf of their employees.

Ultimately, employment and inflation are closely tied to the pace of economic growth overall, so the Fed also closely monitors Gross Domestic Product (GDP) and includes this in its projections. The Fed also forecasts where the federal funds rate will be in the future - a decision over which it has direct control but must make in accordance with what other economic conditions are suggesting.

2019 Fed Funds Rate Discrepancy - 1.35%

The Fed has been particularly good at forecasting the unemployment rate. Its year-end forecasts of where the unemployment rate would be at the end of the following year have typically been off by just 0.13%.

At the other end of the scale, forecasting the fed funds rate has been a particular problem. The typical discrepancy of 0.635% is easily the largest among the four variables the Fed forecasts.

Why does this matter? There are a couple reasons:

  1. The Fed's monetary policy decisions are based largely on trying to anticipate economic developments. The better the FOMC is at seeing what's coming, the better job it can do at smoothing out the bumps.
  2. Releasing these projections is part of a Fed policy of transparency. The Fed knows it's helpful to consumers, businesses and investors if they have some idea what to expect in terms of interest rates and the economy. Sharing its expectations for the year ahead is one way the Fed tries to avoid surprising people, but this only works if those expectations turn out to be close to the mark.

With that in mind, it's of particular concern that the Fed's interest rate forecast for last year was particularly wayward.

More than twice the average discrepancy

At the end of its December, 2018 meeting, the FOMC released a fresh set of projections that included an outlook for where the fed funds rate would finish the following year.

That projection was for the fed funds rate to end 2019 at 2.9%. The actual level turned out to be 1.55%.

This discrepancy of 1.35% was more than twice the average discrepancy since the Fed started making its interest rate projections public. It far exceeded the largest previous discrepancy of 0.775%.

Reality-check

The chart above shows the year-by-year difference between the FOMC's forecast for the fed funds rate and the actual rate at the end of the year.

A perfect forecast would result in the line being at zero, meaning there was no difference between the forecast and the actual rate. As you can see, the forecasts are generally off by a little, but last year's forecast veered the furthest from reality of any year.

Wrong about interest rates - and about the direction of interest rates

Not only was the Fed wrong about the absolute level of interest rates, but it was also wrong about the direction interest rates would move in 2019.

When the Fed made its projections in December of 2018, it had just decided to raise the federal funds rate to 2.4%. Forecasting that rate to be 2.9% at the end of 2019 shows the Fed was expecting a 0.5% rise in interest rates for the year ahead.

Instead, interest rates actually fell by 0.84%.

From household finances to big-money investments, many decisions are based on where interest rates are expected to go. When the Fed is wrong about the level and direction of interest rates, its projections are not at all helpful to those decisions.

Accurate Fed Projections in 2019

On the plus side, it should be noted that the Fed's projections for 2019 were right about some things.

First of all, the projections were spot on about GDP growth and the unemployment rate. The Fed's forecasts of 2.3% real GDP growth for 2019 and a 3.5% unemployment rate at the end of the year were exactly right.

(Note: The GDP growth rate is based on an advanced estimate from the Bureau of Economic Analysis, and this is subject to change.)

The Fed over-estimated inflation. Instead of coming in at 1.9% for the year as predicted, it turned out to be 1.4%.

This over-estimate of inflation may partially explain the Fed's decision to lower interest rates three times in 2019, despite the economy and job market being no weaker than expected.

Lower inflation gives the Fed more latitude to cut interest rates. Lowering interest rates is an attempt to boost the economy; and when concerns about a recession started to spread in early to mid 2019, the Fed showed an abundance of caution by reversing its planned course and lowering rather than raising interest rates.

The Fed's Outlook for 2020

So what does the Fed see in store for 2020?

Projections released at the end of the December FOMC meeting show it expects the economy to slow slightly, from 2.3% real growth to 2.0%. It does not expect this slowing to hurt the job market, however, with unemployment expected to stay at 3.5%.

The latest projections show the Fed expects inflation to strengthen a bit, from 1.4% to 1.9%. This would still be below the Fed's 2.0% long-term inflation target, so it should not trigger any radical change in monetary policy.

Against this backdrop of no major changes in the economy, it should be no surprise that the Fed forecasts little change in the fed funds rate for 2020. That rate ended 2019 at 1.55%; the Fed expects it to end 2020 at 1.60%.

Consumers Have a Choice

For the most part, the Fed is forecasting a "same again" type of year for 2020 - moderate economic growth, low unemployment and low inflation. Along with that, it expects interest rates to stay where they are.

The important thing to know about that is that where interest rates are is an unusually low level. If economic conditions suggest they will stay there, this means two major things for consumers:

  1. Savers need to work to find a better rate

    With interest rates unlikely to rise on their own, consumers need to take action by shopping for a higher rates on savings accounts, money market accounts and CDs.

  2. Borrowers should recognize a good deal while it lasts

    If you've been considering a loan and have budgeted for how to afford the payments, now is the time to act. This is a good time to shop for a loan because rates are low but the economy is still strong enough for lenders to be approving reasonably qualified borrowers.

As the Fed's own forecasting history shows, sometimes the unexpected happens. You should make the best decisions you can based on today's conditions, but never assume conditions will stay the same.

Reality-Check Methodology: Keeping Score on the Fed

MoneyRates conducts its Fed reality check in the following way:

  • MoneyRates compares the Fed's economic projections at the end of one year with the actual data for the following year.
  • Since the actual data may turn out to be either above or below forecast, to measure the average discrepancy over time MoneyRates averages the absolute value of the amount by which the Fed's forecasts were off each year. That way under-forecasting one year does not cancel out over-forecasting the next year.
  • Economic figures are subject to revision, but this analysis uses the most recently available information at the time of writing.

People pay a lot of attention whenever the Fed makes an announcement. This reality check looks back from time to time to see just how much attention those announcements were worth.

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