Recent research has documented that the Federal Reserve produces systematic errors in forecasting inflation, real GDP growth, and the unemployment rate, even though these forecasts are unbiased. We show that these systematic errors reveal that the Fed is “surprised” by real and inflationary cycles. Using a modified Mincer-Zarnowitz regression, we show that the Fed knows the state of the economy for the current quarter, but cannot predict it one quarter ahead.Forecast Evaluation, Federal Reserve, Systematic Errors, Recessions

Frederick L. Joutz

Tara Sinclair

English

Research Papers in Economics

Institute for International Economic Policy Working Paper Series 
Elliott School of International Affairs 
The George Washington University 
 
 
 
 
 
 
 
 
 
Can the Fed Predict the State of the Economy? 
 
IIEP­WP­2008­6 
 
Tara Sinclair 
George Washington University 
 
Frederick L. Joutz 
George Washington University 
 
H.O. Stekler 
George Washington University 
 
 
 
June 10, 2009 
 
 
 
 
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Can the Fed Predict the State of the Economy?
1 
 
Tara M. Sinclair 
Department of Economics  
George Washington University 
Washington DC 20052 
tsinc@gwu.edu 
 
Fred Joutz 
Department of Economics  
George Washington University 
Washington DC 20052 
bmark@gwu.edu 
 
H. O. Stekler 
Department of Economics  
George Washington University 
Washington DC 20052 
hstekler@gwu.edu 
 
 
June 10 2009 
 
JEL Codes:  C53, E37, E52, E58 
 
Keywords: Forecast Evaluation; Federal Reserve; Systematic Errors; Recessions 
 
Abstract 
 
Recent research has documented that the Federal Reserve produces systematic errors in 
forecasting inflation, real GDP growth, and the unemployment rate, even though these forecasts 
are unbiased.  We show that these systematic errors reveal that the Fed is “surprised” by real and 
inflationary cycles.  Using a modified Mincer-Zarnowitz regression, we show that the Fed knows 
the state of the economy for the current quarter, but cannot predict it one quarter ahead.   
 
                                                 
1  We would like to thank Peter Tinsley and Chao Wei for helpful comments and Lauren Taylor for excellent 
research assistance.  M. Al Sadek’s undergraduate thesis provided the stimulus for this paper.  
  1
Can the Fed Predict the State of the Economy? 
 
Monetary policy decisions are based on forecasts of future economic activity. 
Consequently, the Greenbook forecasts made by the Federal Reserve (Fed) staff have been 
extensively evaluated. The forecasts are quarterly predictions made several times each quarter 
with horizons of zero to eight quarters. The staff predicts GDP, its components, various price 
indices, unemployment, etc.  These forecasts should reveal what the Fed knows about the current 
and future states of the economy. 
Recent research has shown that the Fed forecasts contain systematic errors (Joutz and 
Stekler, 2000). Forecasters overestimated the rate of growth during slowdowns and recessions 
and underestimated it during recoveries and booms. Similarly, inflation was under-predicted 
when it was rising and over-predicted when it was declining.  Particularly large errors occurred 
during the periods when prices were rising rapidly during the 1970s and early 1980s.
1   
This paper explores the systematic errors in the Greenbook forecasts of US real output 
growth, inflation, and the unemployment rate to determine if these errors reveal what the Federal 
Reserve knows about the state of the US economy.  If the staff has information on real and 
inflationary cycles, it should be incorporated into the forecasts.  In this analysis, we modify the 
Mincer-Zarnowitz (1969) regression to include dummy variables for the NBER-dated recessions 
and ECRI-dated inflationary cycles.    
We first present the data and the modified Mincer-Zarnowitz regressions. Our results 
show that the Fed forecasts do not incorporate information on recessions or inflationary cycles 
                                                 
1 Hanson and Whitehorn (2006) also observed these systematic errors but associated them with particular time 
periods rather than with stages of the business cycle.  
  2
into the one-quarter-ahead forecasts. This information is contained in the current quarter 
forecasts, indicating that the Fed knows the state of the economy for the current quarter, but 
cannot predict it one quarter ahead. 
I. Data 
  We examine the Federal Reserve staffs Greenbook forecasts for the period 1965IV-
2001IV. The forecasts are for the current quarter and one quarter-ahead for three variables: the 
real output growth rate (GNP from 1965IV to 1991III and GDP from 1991IV on), the GNP/GDP 
deflator inflation rate, and the unemployment rate.  Whenever there are multiple forecasts in each 
quarter, we use the last one.
2   The actual data are the NIPA estimates that are released 
approximately 45 days after the quarter to which they refer.
3  All data, with the exception of the 
unemployment rate, are converted into annualized growth rates.   
  Figures (1a-1d,.., 3a-3d) present data for each variable: the annualized growth rate of real 
GNP/GDP, the annualized inflation rate as measured by the GNP/GDP deflator, and the 
unemployment rate.  The upper left hand graphs display the historical data used in the analysis.  
The other quadrants of these figures display, for each series: the current quarter and one quarter-
ahead forecast errors and the forecast revisions between the current quarter and one-quarter-
ahead forecasts.  
The shaded areas of Figures 1 and 3 represent the dates of these recessions, as defined by 
the NBER.  In Figure 2 the shaded areas represent periods when the inflation rate was increasing 
                                                 
2 We use the last forecast for each quarter because those contain the maximum amount of information on which to 
base current and next quarter forecasts. Forecasts made within the first 10 days of the next quarter are considered 
made in the previous quarter because there would be no new information for the subsequent quarter.  We also 
analyzed forecasts made in the middle of the quarter.  The results were similar. 
3 Use of the real time data avoids definitional and classification changes and is the most consistently available data 
set for our sample.  The terminology for these data releases has varied over the sample.  We obtained similar results 
using the 90 day releases.  
  3
(moving from trough to peak).  The dates for the periods of the inflation cycle were obtained 
from Dr. Anirvan Banerji of the Economic Cycle Research Institute (ECRI). 
II. The Modified Mincer-Zarnowitz  Regression and Results 
The basic Mincer-Zarnowitz  regression is:
4  
  1 , 0 ; , , 1 0 = + + = − − i e F A i t t i t t t β β    (1) 
where At and Ft,t-i are the actual and predicted values for time t.  The forecast is conditional on 
the information available at time t-i.  When i = 0, it refers to a current quarter forecast. For a test 
of informational efficiency, the null hypothesis is: 01 01 and β β = = . A rejection of this 
hypothesis indicates that the forecasts are biased and/or inefficient.  The Wald test and the F 
distribution are used to test this null. 
In order to determine whether the forecasts incorporated information about the state of 
the economy, we modified (1).  Our modified Mincer-Zarnowitz regression (2) is: 
 
 1 , 0 ; , 2 , 1 0 = + + + = − − i e D F A i t t t i t t t β β β  (2) 
where Dt is a dummy that reflects the state of the economy. In the growth and unemployment 
equations, it takes on the value 1 if the economy was in a NBER-dated recession and is zero 
otherwise.  In the inflation equation, the dummy takes on the value 1 from the trough to the peak 
of the inflation cycle as dated by ECRI, zero otherwise.  The joint null hypothesis is: 
01 2 0, 1, 0 and β ββ == = .
5 If the coefficients associated with the dummies are non-zero, the 
                                                 
4 Similar results with respect to the role of the state of the economy can be obtained using the Holden and Peel (1990) 
bias test. 
5 In applying (2) to the forecasts that have a one-quarter lead, the Newey-West procedure was used to estimate HAC 
consistent standard errors in (2).    
  4
dummies contain information that can explain the forecast errors. This indicates that the Fed did 
not include the information on the state of the economy in the forecasts.  
The results are reported in Tables 1a and 1b. The coefficients of the dummy variables 
are not significant in any of the current quarter equations (Table 1a). The estimates for the one-
quarter-ahead predictions (Table 1b) indicate that the dummy coefficient is significant in all 
three equations. Theses results suggest that the Fed does not know what the state of the economy 
will be in the next quarter.  Furthermore, if the Fed did have information on the state of the 
economy, the modified Mincer-Zarnowitz Wald test suggests that all three forecasts reject the 
null of informational efficiency because these forecasts did not incorporate this information.   
In the real GDP growth equation for the one-quarter-ahead forecasts (Table 1b), the 
NBER dummy coefficient is negative, suggesting that the Fed overestimated real GDP growth 
during recessions. In addition, the constant in that equation is positive and significant, showing 
that the Fed forecasts underestimated real GDP growth during expansions.  In the inflation 
equation, the ECRI dummy coefficient is positive, indicating that the Fed underestimated 
inflation when it was increasing (moving from trough to peak in the inflation cycle).  Although 
the constant in that equation is insignificant, it is negative. This suggests that the Fed 
overestimated inflation when it was decreasing (moving from peak to trough in the inflation 
cycle).  We also obtain the expected results in the unemployment equation: the NBER dummy 
coefficient is positive, suggesting that the Fed did not realize the degree of slackness in the labor 
market when in a recession.  All of these statistical results are in accord with the findings about 
systematic errors in the literature.  
  5
III. An Interpretation 
  While the dummy coefficients in the current quarter equations are not significant, they 
are significant in all of the one-quarter-ahead equations. In order to see how the current quarter 
forecasts (Ft,t) differ from the one-quarter-ahead forecasts from the previous quarter (Ft,t-1), we 
examine the revisions in the forecasts.  We are thus comparing forecasts for the same quarter (t) 
made at two different times (t and t-1).  The current quarter forecasts are the last ones that were 
made in each quarter. Consequently, at the end of the quarter there would be virtually complete 
knowledge about the state of the economy in the previous quarter and considerable information 
about the current quarter. 
To determine how knowledge about the state of the economy affected the revisions of the 
forecasts, the revision in the forecast,  1 , , − − t t t t F F , is regressed on the state of the economy, (Dt)  
  t t t t t t D F F υ δ δ + + = − − 1 0 1 , ,  (3) 
Table 2 shows that the coefficients associated with the state of the economy are all significant 
and have the expected signs. Knowing that the economy was in a recession, the GDP forecasts 
for the current quarter are revised downwards and the unemployment prediction is revised 
upwards.  When inflation was increasing, the forecast for the current quarter is revised upwards. 
The evidence indicates that when the Fed forecasters had information about the state of the 
economy, they used the information correctly because these revisions are in the right direction.  
VI. Implications and Conclusions 
  Based on the forecasts made by the Federal Reserve staff, the state of the economy is 
known by the Fed only in the current quarter and is not incorporated into their one-quarter-ahead 
forecasts.  These results suggest that systematic errors can exist in the forecasts (as found by  
  6
Joutz and Stekler, 2000), but they may offset each other over the business cycle.  Given that 
knowledge about the state of the economy is important for setting monetary policy, the Fed’s 
inability to forecast it one quarter ahead is disconcerting.  
References 
Hanson, Michael S. and Jayson Whitehorn. 2006 Reconsidering the Optimality of Federal 
Reserve Forecasts. Manuscript. 
 
Holden K., Peel, D. A., 1990. On testing for unbiasedness and efficiency of forecasts. 
Manchester School, 48, 120–127. 
 
Joutz, F., Stekler, H., 2000. An evaluation of the predictions of the Federal Reserve. International 
Journal of Forecasting 16, 17-38. 
 
Mincer, Jacob and Victor Zarnowitz. 1969. The Evaluation of Economic Forecasts.” in: J. 
Mincer (ed.) Economic Forecasts and Expectations. New York: National Bureau of Economic 
Research. 
 
  
  7
Figure 1.a 1-.d 
 
-15
-10
-5
0
5
10
15
70 75 80 85 90 95 00
1a: Real GNP/GDP
Annualized Growth Rate
-3
-2
-1
0
1
2
3
4
70 75 80 85 90 95 00
1b: Real GNP/GDP Growth
Current Quarter Forecast Error
-8
-4
0
4
8
12
70 75 80 85 90 95 00
1c: Real GNP/GDP Growth
One Quarter Ahead Forecast Error
-8
-4
0
4
8
12
70 75 80 85 90 95 00
1d: Real GNP/GDP
Forecast Revisions
  
  8
Figure 2.a-2.d 
 
-4
0
4
8
12
16
70 75 80 85 90 95 00
2a: GNP/GDP Deflator
Annualized Inflation Rate
-3
-2
-1
0
1
2
70 75 80 85 90 95 00
2b:  Inflation Rate
Current Quarter Forecast Error
-4
-2
0
2
4
70 75 80 85 90 95 00
2c:  Inflation Rate
One Quarter Ahead Forecast Error
-3
-2
-1
0
1
2
3
4
70 75 80 85 90 95 00
1d: Inflation Rate
Forecast Revisions
  
  9
Figure 3.a-3.d 
 
2
4
6
8
10
12
70 75 80 85 90 95 00
3a: Unemployment Rate
-.3
-.2
-.1
.0
.1
.2
.3
70 75 80 85 90 95 00
3b: Unemployment Rate
Current Quarter Forecast Error
-1.5
-1.0
-0.5
0.0
0.5
1.0
70 75 80 85 90 95 00
3c: Unemployment Rate
One Quarter Ahead Forecast Error
-1.2
-0.8
-0.4
0.0
0.4
0.8
1.2
70 75 80 85 90 95 00
3d: Unemployment Rate
Forecast Revisions 
  10
 
Table 1a: Current Quarter Greenbook Forecasts  
Modified Mincer-Zarnowitz Regressions, 
1965IV - 2001IV (Standard Errors in Parentheses) 
 Constant    Slope  NBER 
Dummy 
Inflation 
Dummy 
Wald Test 
Probability 
RealGrowth  0.295 0.990*** -0.411   
  (0.183) (0.042)  (0.339)   
0.13 
INF  -0.326** 1.007***   0.216 
  (0.162) (0.027)    (0.138) 
0.04 
UN  0.001 0.997*** 0.016   
  (0.021) (0.003)  (0.014)   
0.11 
*, **, *** Significant at the 10%, 5%, and 1% level respectively. 
 
 
Table 1b: One Quarter-ahead Greenbook Forecasts  
Modified Mincer-Zarnowitz Regressions, 
1965IV - 2001IV  (Standard Errors in Parentheses) 
   Constant  Slope  NBER 
Dummy  
Inflation 
Dummy  
Wald Test 
Probability
RealGrowth   1.952*** 0.543*** -3.781***   
   (0.597)  (0.162)  (0.586)     
<0.01 
INF   -0.474  0.995***   0.655*** 
   (0.311)  (0.067)      (0.224) 
<0.01 
UN   0.082  0.969*** 0.192**   
   (0.096)  (0.017)  (0.079)     
<0.01 
*, **, *** Significant at the 10%, 5%, and 1% level respectively. 
 
 
Table 2 
Bias Tests for Forecast Revisions 1966I - 2001IV  
(Standard Errors in Parentheses) 
    Constant   NBER Dummy  Inflation Dummy  
RealGrowth   0.127  -1.735***   
   (0.185)  (0.428)   
INF   -0.205    0.457*** 
   (0.116)    (0.149) 
UN   -0.085***  0.167***   
   (0.027)  (0.063)   
*, **, *** Significant at the 10%, 5%, and 1% level respectively. 

Can the Fed Predict the State of the Economy?

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