Do Fed Forecast Errors Matter?*

Abstract

AbstractIn order to make forward‐looking policy decisions, the Fed relies on imperfect forecasts of future macroeconomic conditions. If the Fed’s forecasts are rational, then the difference between the actual outcome and the Fed’s forecast is exogenous to the information set of the Fed at the time the forecast was produced. We investigate the effect of the Fed’s forecast errors on output and price movements under the assumption that the Fed intends to implement policy through a forward‐looking Taylor rule with perfect foresight. Our results suggest that although the mean absolute magnitude of the Fed’s forecast errors is large, the impact on the macroeconomy is reassuringly small, although the impact is larger when we take into consideration the Fed’s inability to forecast recessions.