Wringing The Overoptimism From FOMC Growth Forecasts

If we exclude 2008 and 2009, then the over-optimism in the initial SEP forecasts averaged 1.3 percentage points per year. This figure is substantial considering that the average compound growth rate of U.S. real GDP for the decade following the end of the Great Recession was 2.3%. If the initial SEP forecasts for 2010 onward had actually panned out, then the level of real GDP at the end of 2016 would have been about 9% higher than the corresponding level implied by the BEA’s first reported growth rates.

Eliminating the overoptimism: 2017 through 2019

In a May 2014 speech, William Dudley, then president of the New York Fed, called attention to the “persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years" (Dudley 2014). Quantitative analysis by Lansing and Pyle (2015) confirms this basic idea. A study by Fernald et al. (2017) conjectures that forecasters’ over-optimistic predictions for the speed of the recovery might be due to their failure to account in real-time for a slowdown in U.S. trend growth that, with the benefit of hindsight, appears to have started around 2006.

The accumulation of additional economic data in the decade since the end of the Great Recession now seems to confirm that U.S. trend growth did indeed slow down. For example, Fernald et al. (2017) point out that, despite the disappointing post-recession growth numbers, the pace of growth was nevertheless strong enough to bring about a rapid and faster-than-expected decline in the unemployment rate.

A complementary explanation for the over-optimistic recovery predictions, discussed in Lansing and Pyle (2015), emphasizes a persistent shortfall in aggregate demand. Specifically, forecasters might have overestimated the efficacy of monetary policy - either conventional or unconventional - in the aftermath of a so-called “balance sheet recession." Recessions triggered by financial crises are typically preceded by sustained episodes of bubbly asset prices and debt-financed spending booms. When the bubble bursts, the resulting debt overhang forces borrowers to repair their balance sheets via reduced spending or default. Borrowers have too much debt, so monetary policy actions designed to encourage more borrowing by lowering interest rates are less effective. Balance sheet recessions are typically followed by sluggish recoveries in output. Some have argued that balance sheet recessions also scar potential output, leading to permanent output losses, such that real GDP never returns to its pre-crisis trend.

In addition, forecasters’ review of their own track records would likely have motivated a shift in methodology aimed at eliminating their prior optimistic bias. The theory of rational expectations predicts that economic agents will adjust their forecasts over time to eliminate any systematic bias towards optimism or pessimism. Consistent with this idea, the SEP central tendency midpoint forecasts for longer-run real GDP growth have ratcheted down gradually from about 2.7% in late 2009 to around 1.9% in 2016 where it has remained ever since.

Figure 4 shows the evolution of the SEP central tendency midpoint growth forecasts for the years 2017 through 2019. The pattern of forecast revisions is clearly different from the patterns observed in Figures 1 through 3. First, the forecasts for 2017 through 2019 all started out low - in the vicinity of 2% growth. These initial forecasts are close to the downwardly-revised SEP central tendency midpoint forecasts for longer-run real GDP growth. Second, the growth forecasts for 2017 through 2019 were all revised up over time - implying some conservatism in the initial forecasts. Indeed, the BEA’s first reported growth rates for these years all came in higher than the initial SEP forecasts. Third, the cumulative forecast revisions for these years are much smaller on average than in the past. The net upward forecast revision for the years 2017 through 2019 averaged +0.5 percentage points per year. Taken as a whole, these observations suggest that SEP participants adjusted their forecast methodology to eliminate the prior optimistic bias.

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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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