Models, Data and US Federal Reserve Policy Decisions

 

One January 11, 2024, the PBS News Hour interviewed Raphael Bostic, president of the Atlanta Federal Reserve Bank. One interesting part of the interview was the description of how models vs. data are used in the Federal Reserve decision making process, at least by Dr. Bostic. The role of economic models in decision making is interesting because on July 20, 2010 the US House of Representatives Committee on Science and Technology held a hearing on the topic (transcript here) and concluded the models were not very useful. My conclusion is that the US Fed is on the right path with some of the new models being developed. Future posts will give my recommendations (as a statistician) and my reasons for making them. It is essentially my forecast for the future of US Fed model building.

In the interview above, Amna Nawaz asked when Bostic expected the economy to reach the US Fed's 2% Inflation rate target. Bostic answered:

Well, we have models, and models will give us an answer...[but]...I don't put too much stock in any of those longer-term issues...I just try to keep an eye on where things are going month to month and try to just have a clear understanding about where we stand.

In other words, the models give us some long term predictions about Inflation and Economic Growth but, for month-to-month decision making we use data.

So what exactly can we get from models? I would hope that that the Atlanta Fed gets Prediction Intervals telling them that, say, Inflation might be between 1% and 3%, bracketing he 2% target. Then, as the data come in, it can be evaluated to answer Anna Nawaz's question. And, I would hope that the state of the economy would have some role in predicting the time path of inflation. Something like the prediction intervals produced by Climate Models:

The original topic of the News Hour interview was to gage the actual strength of the economy and consumers expectations about economic growth (although most of the interview concentrated on Inflation).

 For the strength of the economy, let's look at the Atlanta Fed's GDPNow forecast for economic growth (quarterly percentage change in real GDP). The output from the GDPNow app (presented above) compares the GDPNow forecast to the range of the top and bottom ten Blue Chip forecasts. GDPNow predicts GDP percentage changes well outside the Blue Chip forecasts until we get into March of 2023. What's going on here and why is this happening?

Maybe it would help to look at a longer time period. The St. Louis Fed publishes the GDPNow output from 2014-2024 (above and here). We can very clearly see the COVID shock, the economy's response, and the return to approximately at 2% growth rate. Note that it took approximately three years to recover from the COVID shock.

There is a lot to scratch your head about in the NewsHour interview and the outputs of the GDPNow model before we even get to thinking about the problem of inflation. Why don't the Blue Chip forecasts show the COVID shock? Why does the GDPNow cellphone App not go back to 2019, before COVID, to report results? And, which forecast should we believe, if any? 

It sounds as if, from Dr. Bostic's comments, that the FED ignores the forecasts and just waits for data to come in when making decisions about the economy. That's OK, but the FED spends a lot of time and money on large-scale, Dynamic Stochastic General Equilibrium  (DSGE) models (here), the models criticized in the Congressional Hearings, models that produce yet another set of forecasts. Worse yet, the DSGE models are based on assumptions that economic agents use models to form expectations about economic variables and use these expectations to make decisions, decisions that DSGE models attempt to predict.

But, which models specifically are economic agents using: the GDPNow model, the consensus of the twenty-or-so Blue Chip forecasting models, the forecasts of the DSGE models, or some other model entirely (I have my own models that are similar to but, I argue, an improvement over the GDPNow approach). I know the Fed is trying to be transparent and lay everything out on the table but what I'm looking at appears contradictory as it must have looked to Congressional Committees. And,  some commentators (here) and Congressmen (here) want to get rid of the Federal Reserve, Fed forecasts and Fed policy manipulations entirely.

Interestingly enough, the current problems with Economic Policy all point back to our failure to understand the Great Depression* and the effects of economic shocks (such as the WWI-WWII shocks and the COVID shock). In future posts, I'll try to untangle this mess** because I think it is interesting and important but not because I think any economic agents (to include the Fed and the ECB***) will be interested. Eventually, I will get around to looking at Inflation and Deflation!

Notes

* ChatGPT (here) lists the following causes for the Great Depression: (1) Stock Market Crash of 1929, (2) Bank Failures, (3) Reductions in Consumer Demand, (4) High Tariffs and Trade Barriers, (5) Monetary Policy Mistakes, (6) Debt Deflation, (7) Decline in International Economic Activity and (8) The Dust Bowl and Agricultural (Environmental) Collapse. 

** My working hypothesis is that we need to embed the US Economy within the World-System to not only understand the Great Depression but also to understand current economic policy confusions. The Fed doesn't really have a role for the World-System in its models.

*** The failure of Macro-economic models was also felt by the European Central Bank (ECB): "Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner".