Kevin L. Kliesen

English

Research Papers in Economics

June 2005 NationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
O
n June 30, 2004, when the FOMC upped its intended
federal funds rate by 25 basis points to 1.25 percent,
the data indicated that core CPI had risen by about
1.75 percent for that year (May 2003 to May 2004) and yields
on 10-year Treasury securities had averaged about 4.75 per-
cent that month. It worried policymakers somewhat that core
inflation and long-term interest rates had moved noticeably
higher over the previous few months and that the spot price
of crude oil (West Texas Intermediate) was up a little less
than 25 percent from a year earlier. Still, the latest Blue Chip
Consensus forecast projected solid real GDP growth in 2005
(3.5 percent), with moderate CPI inflation (2.2 percent); the
Blue Chip does not forecast the core CPI.
As it stands now, the federal funds rate has been raised
to 3 percent and oil prices are up even more; however, as
seen in the chart, the Blue Chip Consensus forecast for real
GDP growth has been remarkably stable. Indeed, the forecast
for real GDP growth in 2005 has remained within a fairly
narrow range for most of the past year despite a rise in the
spot price of oil to an average of $54.31 per barrel by March
2005, an increase of more than 58 percent since January
2004. (The chart indexes oil prices to be 1 in January 2004.) 
In a recent speech, Federal Reserve Bank of St. Louis
President William Poole remarked that “the stability of the
economy is reflected in the stability of the forecasts.” But
while forecasts for real GDP growth in 2005 have been
remarkably stable, forecasts for core CPI inflation in 2005
have been moving steadily higher. According to the 
private-sector forecasting firm Macroeconomic Advisers,
the expected increase in the core CPI in 2005 has risen
from 1.7 percent in January 2004 to 2.5 percent in May
2005. If realized, the 2005 increase would be the highest
core inflation rate in four years.
The steady rise in core inflation forecasts is potentially
worrisome in view of the role that expectations have come
to play in the policymaking process. Over time, monetary
policymakers have realized that they can potentially exert
influence over economic activity by affecting expectations
of future inflation. Hence, a key part of economic stability
is the expectation of low inflation.
Yet, as the chart also shows, financial markets appear
to have shrugged off the upcreep in expected core inflation.
After peaking at an average of about 4.75 percent in
June 2004, the yield on the 10-year Treasury security has
dropped to about 4 percent. The fall in long-term interest
rates in the face of rising inflation, higher oil prices, and
continued solid growth prospects is something of a puzzle.
If anything, a decline in long-term yields in the face of stable
economic growth prospects usually means the market is
betting on lower future inflation—implying that the market
views the recent rise in inflation as temporary. 
But another view emerged in May, as forecasters trimmed
their 2005 real GDP growth forecast to 3.2 percent. This
revision, more or less, was consistent with the story that
long-term interest rates were declining because of an expec-
tation of weaker growth going forward (lower real yields).
It is possible, though, that this downward revision in the 2005
forecast was a response to the weaker-than-expected advance
estimate of first-quarter real GDP growth (3.1 percent). Since
then, first-quarter growth has been revised upward to 3.5
percent and several indicators of economic conditions in
April have come in much better than expected. If nominal
interest rates continue to remain stable in the face of solid
growth, then the interest rate puzzle may simply reflect a
more sanguine inflation outlook from the bond market than
from forecasters. 
—Kevin L. Kliesen
research.stlouisfed.org
Battle at Bond Bluff: Forecasters vs. Financial Markets
5.0
4.0
3.0
2.0
1.0
2.00
1.75
1.50
1.25
1.00
0.75
0.50
Jan
2004
Mar
2004
May
2004
Jul
2004
Sep
2004
Nov
2004
Jan
2005
Mar
2005
May
2005
June 2004
10-Year Yield
Real GDP Growth
Oil Prices (Index)
Core CPI
SOURCE: Federal Reserve Bank of St. Louis, Blue Chip Indicators (real GDP),
and Macroeconomic Advisers (Core CPI).
Percent Index, January 2004 = 1.0
Forecasts for 2005 (Q4/Q4) and Oil Prices and 
Long-Term Interest Rates

Battle at bond bluff: forecasters vs. financial markets

http://research.stlouisfed.org/publications/net/20050601/cover.pdf

Battle at bond bluff: forecasters vs. financial markets

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