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Reality Check: Evaluating the Federal Reserve Board

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arrows_in_targetHow good a handle does the Federal Reserve have on the economy?

The Fed gets a great deal of attention for the impact it has on the economy, and certainly its federal funds rate and monetary policy decisions have significant influence on the financial markets and the economy in general. However, the Fed does not exercise anything close to absolute power over the economy, so its decisions have to be based on anticipating where economic conditions are heading and how they might be adjusted.

So, one key way to evaluate the Fed is by considering whether it has successfully anticipated economic conditions or not.

MoneyRates.com examined this question by looking at the economic projections the Federal Open Market Committee (FOMC) made at each of the last Fed meetings before the start of 2015, 2016, 2017, and 2018. Then we compared the FOMC's projections for each new year to reality just to see how accurate they were.

Turns out, the Fed's economic forecasts are not bad, though some are better than others. Interestingly, the Federal Reserve Board was especially off the mark when it came to forecasting its own interest rate decisions.

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.

How accurate is the Fed?

Anticipation is an important factor when it comes to guiding the economy productively and without undue disruption. Think of it as smoothly steering a car: If you could only see a few feet ahead, you would need to constantly swing the steering wheel from side to side to react to new conditions as they appear. But, if you are able to focus further down the road as it stretches out, you can steer more smoothly as you anticipate changes in conditions.

So how has the Fed done in anticipating economic conditions? The table below shows how accurate the Fed has been over the past four years in forecasting the unemployment rate, PCE inflation, GDP, and federal funds rate levels.

Accuracy of Federal Reserve Economic Projections for the Next 12 Months
(2015 - 2018)
Economic IndicatorAverage Discrepancy
Unemployment Rate0.16 percent
PCE Inflation0.43 percent
GDP0.35 percent
Fed Funds Rate0.46 percent

One curiosity about this track record is that the Fed has been furthest off when it comes to forecasting the federal funds rate one year ahead, even though this is the one indicator whose outcome the Fed can directly control. Even so, its less-than-perfect record in this regard can be a source of comfort in a way.

A concern that manifested itself when the Fed was steadily raising rates last year was that it was following a predetermined course without being sensitive to warning signs in the economy and financial markets. If you look at the track record, though, the Fed has shown a willingness to deviate from its own interest rate projections, based on what economic conditions indicate. Apparently, the Fed's read on those conditions has been pretty accurate. It will be worth watching whether it can keep it up.

Overall, this is not a bad record. For each of these economic indicators, the Fed has generally been off by less than half a percent in its projections for the year ahead. It would be interesting to see whether any of the Fed's critics could consistently do as well in their predictions.

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