Private information of the Fed and predictability of stock returns

Abstract

This article investigates whether the Federal Reserve's (Fed's) private Gross Domestic Product (GDP) growth forecasts, as reported in the Greenbook of the Fed, contain information about future real and excess stock returns. I implement long-horizon regressions to analyse the predictive power of the Fed's GDP growth forecasts. The regressions conclude that the Fed's GDP growth forecasts can be used to predict long- and short-term stock returns. The size of the coefficient of the Fed's orthogonal GDP growth forecast indicates that 1% increase in the Fed's forecast predicts 2–4% decrease in real and excess stock returns. The regressions considering the size effect suggest that the predictive power of the Fed's GDP growth forecasts increases as the size of the portfolio decreases. A comparison of the Fed's forecasts and the commercial forecasts shows that the Fed's GDP growth forecasts contain information that does not exist in the commercial forecasts. I investigate the sources of the Fed's superior private information and predictive power. Analysis suggests that the source of the predictive power of the Fed's GDP growth forecasts is the private information about future surprise monetary policy actions embedded in them.