Research Discussion Paper – RDP 2017-01 Gauging the Uncertainty of the Economic Outlook Using Historical Forecasting Errors: The Federal Reserve's Approach Abstract
Since November 2007, the Federal Open Market Committee (FOMC) of the US Federal Reserve has regularly published participants' qualitative assessments of the uncertainty attending their individual forecasts of real activity and inflation, expressed relative to that seen on average in the past. The benchmarks used for these historical comparisons are the average root mean squared forecast errors (RMSEs) made by various private and government forecasters over the past twenty years. This paper documents how these benchmarks are constructed and discusses some of their properties. We draw several conclusions. First, if past performance is a reasonable guide to future accuracy, considerable uncertainty surrounds all macroeconomic projections, including those of FOMC participants. Second, different forecasters have similar accuracy. Third, estimates of uncertainty about future real activity and interest rates are now considerably greater than prior to the financial crisis; in contrast, estimates of inflation accuracy have changed little. Finally, fan charts – constructed as plus-or-minus one RMSE intervals about the median FOMC forecast, under the expectation that future projection errors will be unbiased and symmetrically distributed, and that the intervals cover about 70 percent of possible outcomes – provide a reasonable approximation to future uncertainty, especially when viewed in conjunction with the FOMC's qualitative assessments. That said, an assumption of symmetry about the interest rate outlook is problematic if the expected path of the federal funds rate is expected to remain low.
This paper is being jointly released by the Board of Governors of the Federal Reserve System as Finance and Economics Discussion Series (FEDS) Paper 2017-020. Reflecting the joint release, American spelling and usage are used. Also, reflecting the focus on Federal Reserve practices, while the text and tables have been reformatted in line with the RBA Research Discussion Paper series, the figures are in the same format as is used in the FEDS version.