Forging Fed forecast illusions

Earlier this week the Federal Reserve board announced plans to do something quite radical. From this month the Fed will release publicly the individual projections of its members for the target federal funds rate for the fourth quarter of the year as well the "next few" years, along with their projections of the likely timing of the first increase in the target rate.

The announcement of the Fed's decision, while in line with a trend over more than a decade and a half of increasing transparency by the Fed and other central banks, including the Reserve Bank of Australia, isn't being seen universally as a positive move.

Indeed, even among the board members there was some dissent, with some members arguing that rather than releasing 17 sets of individual projections four times a year the Fed should publish a consensus view, while others were concerned that the projections would be interpreted as signalling the Fed's actual policy path.

There is an obvious reason for the Fed decision. Despite what is effectively a negative real Fed funds rate, and several bouts of quantitative easing, the US economy remains comatose. Last year the Fed tried to inject some confidence into the market by providing reassurance that rates would remain "exceptionally low" through to the middle of 2013. That reassurance has had little impact.

The new policy is an extension of that strategy of trying to provide the confidence to individuals and businesses and lenders that will encourage them to make investments and loans and generate some activity and jobs. It could enable the Fed to manage expectations more effectively.

The Fed can afford, at this moment at least, to provide longer-term projections – which the market will inevitably see as a guide to its future actions – because the outlook for unemployment and economic growth in the US, and therefore inflation, is so bleak that there is little prospect of any meaningful increase in official rates for at least several years.

Other central bankers, and particularly the RBA, aren't necessarily in that same position and would be wary of emulating the Fed.

By publishing the projections of its individual members, along with their analyses of the underlying conditions and assumptions behind the projections, the Fed will reveal any significance differences between its members. It could also damage the credibility of some of those individuals – or of the Fed as a whole – if they are shown to have badly misread the direction of the economy over time.

There is a certain mystique about the economic credentials of central bankers and of the privileged insights they have into the condition of their economies, despite plenty of evidence to the contrary over decades.

The desire not to be seen to have misled markets could also distort the Fed's actual decision-making or generate less extreme volatility if the central bank's actions depart significantly from the guidance provided by the projections.

Late last year the RBA governor, Glenn Stevens, gave a speech about the use of forecasts in which he said it would be vastly preferable if discussions of forecasts were couched in more "probabilistic" language than tends to be the case and referred to the "inherent uncertainties" in the forecasting process.

Referring to the RBA's latest published outlook he said that, absent large shocks to oil prices or the Australian dollar or a serious downturn in the global economy, Australia's inflation rate in 2012 had a "pretty good chance" of being between two per cent and three per cent. The chances of a similar outcome in 2013 were also "reasonable", although with a slightly higher probability that inflation would end up above three per cent.

"A big change in any of the variables subject to assumptions would quite easily push outcomes away, and maybe a long way away, from the forecast," he said.

The RBA, of course, has had practical experience of the difficulties of forecasting for even relatively short periods ahead. Last year it was biased towards raising rates for most of the year because of its expectation that the inflation rate would rise – but ultimately it cut the cash rate, twice, at the end of the year.

That perhaps illustrates the major criticism of the Fed's policy. It promotes the illusion that central banks can predict the economic future with a degree of precision that isn't actually achievable and encourages participants within the economy to act on that illusion. There would be no point in the Fed publishing the projections unless it believed they would have an impact on behaviour.

The greater transparency around central bank decision-making – the release, after an interval, of the minutes of board meetings, for instance – has been useful in creating a better understanding of how the banks think and operate.

There might be a point, however, where too much information might not only create confusion but have unintentionally damaging consequences.