Insight Line—December 3, 2007

We’ve all had the experience: perusing aisles of fully assembled toys or furniture only to discover a large tag clearly marked “Display Only.” The one you take home is packaged in the rather flat box below bearing the words “Some Assembly Required.” Investors now find themselves in that same situation, in that the quarterly multi-year economic forecast from the Federal Reserve Open Market Committee (FOMC) is for display only. Some assembly is required.

According to FOMC Chairman Ben S. Bernanke, the newly revised format for economic forecasts from the FOMC is a major step toward improving monetary policy transparency. Granted, expanding the number of forecasts to four from two, lengthening the forecasted period from 18 months to three years and simultaneously releasing commentary delineating the underlying rationale of the consensus forecast is a quantum leap from years past. Historically speaking, discerning direction, let alone change, to monetary policy was somewhat akin to reading tea leaves. So who can fault investors if, in the mad rush to get the new and improved forecast out of the box, they left the instruction manual for later?

You see, simultaneous to Dr. Bernanke’s display of two newly scheduled quarterly forecasts,¹ David Reifschneider and Peter Tulip of Federal Reserve Board’s economic staff were just putting the finishing touches on “Gauging the Uncertainty of the Economic Outlook from Historical Forecasting Errors.”²

In this paper the authors note, “The purpose of this paper is to provide background information on the magnitude of uncertainty seen on average over history, as an aid to public understanding of the Committee’s qualitative assessments of the current situation.”³ Said differently, this paper is what I believe to be the instruction manual for the proper use of FOMC quarterly multi-year forecasts.

Seeking to discern the accuracy of FOMC economic forecasts, the researchers candidly assess the accuracy of not only historical forecasts from FOMC participants, but also from the Federal Reserve Board’s economic staff, the Congressional Budget Office, the Presidential administration, the Blue Chip consensus forecast and the Survey of Professional Forecasters. Not surprisingly they conclude, “All macroeconomic forecasts are subject to error,”⁴ and depending on the economic statistic and the calendar quarter in which the forecast appears, some much more than others.

Nevertheless, Reifschneider and Tulip suggest that these shortcomings do not necessarily make forecasting an exercise in futility. Rather their analysis serves as sober reminder to investors that static forecasts of dynamic outcomes are fraught with pitfalls. As such, the researchers argue that the more logical way to use the FOMC forecasts is to convert them to probabilities rather than claim them as certainties.

With the benefit of hindsight and mindful of past studies on the accuracy of economic forecasts, the researchers position that it is possible to analyze forecast miscalculations in order to determine an average root mean squared error (in effect, the magnitude of the error,) and apply it to future forecasts.⁵ For example, say the FOMC’s October (autumn) forecast for the nation’s gross domestic product (GDP) over the coming year is 2.5 percent. Reifschneider and Tulip calculate the average root mean squared error for the current autumn forecast is 0.26. Therefore, unexpected events aside, investors should have a high degree of confidence that 70 percent of the time the actual final GDP data will lie within the range of 2.25 to 2.75 percent. Similar calculations apply to the FOMC’s current and future quarterly forecasts for unemployment, the personal consumption expenditure index, and the personal consumption expenditure index excluding-food and energy (also known as core inflation). In other words, in order to understand the meaning of the forecast, investors need to assemble all the parts.

To be sure, the Bernanke FOMC is indeed expanding on the groundwork of former FOMC Chairman Alan Greenspan, as they strive for a more open policy communication. Then again, plain English is not yet the order of the day. Therefore, when it comes to interpreting the FOMC’s economic forecasts with an eye toward monetary policy actions, I suggest the admonishment found at the beginning of most instruction manuals—read instructions entirely before beginning—is apropos.

¹ Bernanke, Ben S. “Federal Reserve Communications,” speech at the Cato Institute 25th Annual Monetary Conference, Washington, D.C., November 14, 2007 Available at http://www.federalreserve.gov/newsevents/speech/bernanke20071114a.htm The original forecasts of February and July are expanded to include May and November.

² Reifschneider, David and Peter Tulip, “Gauging the Uncertainty of the Economic Outlook from Historical Forecasting Errors,” Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., November 19, 2007. Available at http://www.federalreserve.gov/pubs/feds/2007/index.html

³ Reifschneider and Tulip, page 1

⁴ Reifschneider and Tulip, page 3

⁴ The complete listing of adjustment factors is found in Reifschneider and Tulip, page 30, table 4.

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.