Insight Line—February 25, 2008

Investors have long suspected that the Federal Reserve Board (the “Fed”) is privy to economic information unavailable to most private forecasters. And, their suspicions are well founded. Unfortunately, however, investors fail to leverage the opportunity of this insight.

The Federal Reserve’s capacity for data gathering is unprecedented in its breadth and depth. One of the most important compilations of this data is the “Green Book” used at each Federal Open Market Committee (FOMC) meeting. The Green Book contains Federal Reserve Board staff forecasts on inflation and real gross domestic product growth over the ensuing 12 quarters. Strikingly, the historical accuracy of the Green Book’s forecasts on inflation and output appears, on balance, to exceed the accuracy of private-sector forecasts. In fact, one oft-cited analysis years ago from Christina and David Romer of the University of California, Berkley, concluded, “Our results suggest that someone with access to both the Federal Reserve and commercial forecasts should not just put positive weight on the Federal Reserve forecast, but put little weight on the commercial one.”¹

All of which raises the question: Does the Fed have superior economic information to that produced by the numerous and varied federal agencies and private sector sources?

The answer, as I see it, is yes.

In a study titled, “Does the Fed Possess an Exploitable Information Advantage?”² researchers from the Federal Reserve Bank of Boston suggest that it does. The study asserts that the Federal Reserve’s bank supervisory role provides the Federal Reserve with access to sensitive and non-public information about the financial condition of member banks, the inclusion of which can markedly improve longer-term economic forecasts. Furthermore, in that the Fed constructs economic forecasts from information unavailable to private forecasters, the authors maintained that the longer-term accuracy of the Fed’s economic forecasts could routinely exceed those produced by the private sector.

And that’s the point. The Fed’s data is better. In fact, the Romers recently offered new research that goes one step further in attempting to isolate and identify the source of the Fed’s information advantage. In comparing FOMC voting members’ forecasts to Federal Reserve Board staff forecasts, the Romers found that economic forecasts from voting members appear subject to the same shortcomings and impreciseness as those in the private sector. They suggest, “Someone wishing to predict inflation and unemployment who had access to the forecasts of both the FOMC and the staff would be well served by discarding the FOMC forecast and just using the staff predictions.”³

The implication for investors, in my view, is that some selectivity is warranted when evaluating Fed forecasts. Granted, the existence of the Green Book leaves little doubt the FOMC’s policy actions and its members’ economic prognostications are informed by superior information unavailable to the public. But if the Romers’ contentions are indeed borne out, public utterances from FOMC voting members on the perceived course of the economy should receive little more than polite acknowledgement from investors.

Such a conclusion plays heavily into the current investment environment. You see, with economic forecasts seemingly becoming the lynchpin to political and investment decisions throughout 2008, investors are right to ask, where might they turn to cut through all of the noise?

Well, if the Romers are correct, the informational content of the economic forecasts from the Fed’s own staff as detailed in the semi-annual Monetary Policy Report to the Congress holds great promise.

¹ Romer, Christina D., and David H., “Federal Reserve Information and the Behavior of Interest Rates,” American Economic Review, June 2000.

² Peek, Joe, Eric Rosengren and Geoffrey M.B. Tootell, “Does the Federal Reserve Possess an Exploitable Informational Advantage?” Federal Reserve Bank of Boston, September 30, 1999.

³ Romer, Christina D. and David H., “The FOMC Versus The Staff: Where Can Monetary Policy Makers Add Value?” National Bureau of Economic Research, Working Paper 13751, January 2008, page 12.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.