Central Banks CAN’T Forecast Better, So Why Trust Them?
A quick and easy way to see if central banks really have more insight into the future is by looking at their forecasting record.
Since inflation tends to be their mandate and main focus, let’s take a look at how their forecasts panned out.
Beginning with the Fed, the chart below shows the FOMC’s projections of the percentage change in the Core PCE on a yearly basis (a year as measured from one 4th quarter to the next), compared to actual readings of the Core PCE data series.
The shaded area represents the difference between the High and Low central tendencies of that forecast for a particular year.
The Fed establishes the central tendency of its Core PCE forecasts by excluding the three highest and three lowest projections.
We can see that their forecasts have not been very accurate.
If they had been, then the line representing the Core PCE (purple) would sit firmly in the shaded area, between the high and low central tendencies. Instead, we see that the Fed has consistently forecast inflation to be higher than it turned out to be since 2004.
In addition, the FOMC has not been able to forecast steep falls in the Core PCE during the two crisis periods in the data set, 2008 and 2020.
This is related to them following, rather than leading, the market in terms of setting interest rates. The Fed only cut the Fed Funds Rate in an appreciable manner after the market had already made its high, in the run up to both events.
Which really is another way of saying that the Fed did not, and cannot, forecast future economic crises.
What about other central banks, like say, the ECB?
Unfortunately, the Europeans don’t fare much better, with their forecasts also consistently differing from actual inflation readings.
From the chart above, we can observe that in the years leading up to the Great Financial Crisis to about the end of the Eurozone sovereign debt crisis, the ECB consistently underestimated inflation. Then, in the years after, they have consistently overestimated what the HICP would turn out to be.
Note that the chart depicts the Winter series of projections made by ECB staff for annual changes in the HICP. Also, the HICP series plot reflects the annual change in the Overall Index for the Euro Area as a whole, taking into account the changing composition of member states over the years.
The point of all this is to demonstrate that central banks really experience the same problems as everyone else when it comes to forecasting – doing it accurately, much less consistently, is an impossible endeavor.
This, however, is not an indictment against them, since they are human after all, and cannot see into the future.
However, implicit in the widespread belief that central banks make effective policy decisions is the acknowledgement that they can predict what will happen, at least to some degree. But as their inflation forecasting record clearly shows, they can’t.
Why then do people continue to trust that they can?
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