Do Fed Forecast Errors Matter?

There is a large literature evaluating the forecasts of the Federal Reserve by testing their
rationality and measuring the size of their forecast errors. There is also a substantial
literature and debate on the impact of the Fed’s monetary policy on the economy. We
know little, however about the impact of the Fed’s forecast errors on economic
outcomes. This paper constructs a measure of a forecast error shock for the Federal
Reserve based on the assumption that the Fed follows a forward-looking Taylor rule.
Given the effort the Fed puts towards producing forecasts that do not have an
endogenous error component, we treat the Fed’s forecast errors as a shock, analogous
to a monetary policy shock. Our shock, however, is different in that it is completely
unintended by the monetary authority rather than simply unanticipated by the public. We
follow Romer and Romer (2004) and investigate the effect of the forecast error shock on
output and price movements. Our results suggest that although the absolute magnitude
of the forecast error shock is large, the impact of the shock on the macroeconomy is
quite small. This finding is robust across a range of different specifications. The
maximum impact suggests a decline of less than 0.3 percent of real GDP and less than
0.4 percent of GDP deflator in response to a 100 basis point contractionary forecast
error shock.