Wringing The Overoptimism From FOMC Growth Forecasts

Source: Federal Open Market Committee Minutes, S&P 500.

Figure 2

SEP central tendency midpoint forecasts: 2011 to 2013

(Click on image to enlarge)

Notes: S&P 500 change is the 12-month percent change. Dots mark the SEP forecast release dates; X marks the BEA’s first reported Q4/Q4 real GDP growth rate for the year, typically released in January of the following year.

Source: Federal Open Market Committee Minutes, S&P 500.

Figure 3

SEP central tendency midpoint forecasts: 2014 to 2016

(Click on image to enlarge)

Notes: S&P 500 change is the 12-month percent change. Dots mark the SEP forecast release dates; X marks the BEA’s first reported Q4/Q4 real GDP growth rate for the year, typically released in January of the following year.

Source: Federal Open Market Committee Minutes, S&P 500.

In all three figures, the initial SEP forecast for a given year is higher than the final forecast for that same year - implying a net downward revision to the forecast. The pattern of revisions from the initial to the final forecast appears roughly correlated with movements in the S&P 500 index. These movements would be expected to capture investors’ reactions - and perhaps FOMC meeting participants’ reactions - to incoming economic data and its implications for future growth, among other things. The net downward forecast revisions for the years 2008 through 2016 averaged - 1.6 percentage points per year. Excluding the Great Recession years of 2008 and 2009, the net downward revision averaged - 1.3 percentage points per year. The largest net downward revision in the post-recession years was - 2.4 percentage points for 2012.

One way to assess forecast accuracy is to compare the initial SEP forecast to BEA’s first reported growth rate. With the exception of 2010, the initial forecasts for the years 2008 through 2016 were all higher than the BEA’s first reported growth rate for that year - implying overoptimism in the initial SEP forecasts. Overoptimism for the years 2008 through 2016 averaged 1.5 percentage points per year. Two of the largest measures of overoptimism occurred for the recession years of 2008 and 2009, when the initial SEP forecasts exceeded the BEA’s first reported growth rates by 2.3 and 2.4 percentage points, respectively.

It is perhaps not surprising that the SEP participants failed to predict the Great Recession. In a cross-country study of professional economic forecasters from 1989 to 1998, Loungani (2001) finds that “the record of failure to predict recessions is virtually unblemished."

Notwithstanding the typical failure to predict recessions, it is worth considering whether some warning signals about the Great Recession went unheeded. The report of the U.S. Financial Crisis Inquiry Commission (2011) states, “Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted" (p. xvii). The report lists such red flags as “an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, [and] dramatic increases in household mortgage debt." In an analysis of the New York Fed’s failure to predict the Great Recession, Potter (2011) identifies three main culprits: a “misunderstanding of the housing boom…[which] downplayed the risk of a substantial fall in house prices"; a “lack of analysis of the rapid growth of new forms of mortgage finance"; and the “insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy."

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Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the ...

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