Overoptimistic Fed strains credibility on forecasts

By Lindsay Dunsmuir

WASHINGTON (Reuters) - The economic projections of Federal Reserve policymakers released on Wednesday anticipate U.S. economic growth at 2.4 percent next year and a rebound in inflation to 2 percent by 2018.

The new projections came as the Fed carried out its first rate hike in almost a decade and set out a path for rate rises for 2016 that projected a 1.375 percent year-end federal funds rate.

But Fed policymakers have a mixed record in predicting the nation's economic health, casting doubt on their ability to set a rate path that will keep one of the longest-running yet most anaemic recoveries in modern history on track.

An analysis of the rate-setters' year-ahead projections over the past five years shows they have generally overestimated real GDP growth and inflation, while underestimating improvement in the unemployment rate.

(Graphic: http://tmsnrt.rs/222o3yq)

"I think it's fair to say that the (policymakers) were slow to recognise the Great Recession had a big negative impact on potential growth, and slow to internalize that into the way the Fed thinks about the economy," said Lewis Alexander, an economist at Nomura.

The Fed publishes the participants' anonymized predictions for key economic indicators, organised as a range. It also publishes the so-called central tendency, which excludes the three highest and three lowest projections.

Actual GDP growth in both 2011 and 2012 was lower than the most pessimistic forecast among Fed policymakers' full range of predictions. Since 2010, the midpoint of the central tendency has been on average 0.8 percentage points too high.

In 2010 the midpoint of policymakers' predictions was 3.3 percent for 2011. Actual GDP growth was 1.7 percent. In 2011 the midpoint of forecasts was 2.7 percent for 2012 and the outcome was 1.3 percent.

The Fed has underestimated the pace of labour gains in the past four years, missing on average by half a percentage point.

The pace of inflation has consistently run well below the Fed's 2 percent target. Fed policymakers overestimated inflation in 2010, 2013 and 2014 and on a year-ahead basis was too optimistic for 2015. This year, actual inflation will be completely outside the policymakers' range of predictions.

RISKY BUSINESS

It is not just in a recovery the Fed gets it wrong.

Herman Stekler of George Washington University and coauthor Hilary Symington showed that throughout 2007 policymakers recognised downside risks to growth, but up until just before the start of the last recession considered that inflation risks were more of a concern. It was not until October 2008 that the focus on inflation subsided.

Between 1992 and 2003, a period of generally high growth, the Fed's policymakers tended to under predict GDP growth outcomes and predict too high inflation and unemployment, according to Simon Sheng of American University.

Janet Yellen is still reliant on traditional economic models that in 1996 led her to say she would support a rate hike based on risks of rising inflation, only to be overruled.

The fear is that the Fed may still be overly dependent on fixed economic ideas on the link between growth, unemployment and inflation that could lead it to tighten monetary policy too quickly.

"They're no worse than anybody else and we're all terrible," said Paul Ashworth, an economist at Capital Economics.

In a news conference after the Fed's meeting on Wednesday, Yellen acknowledged that theories underlying forecasting are not perfect and are subject to uncertainty.

"We throw out models that are persistently not working," she said.

And the world's most powerful central bank does seem aware that its record has the potential to dent its credibility.

Chicago Fed president Charles Evans said earlier this month that policymakers' prediction efforts were "embarrassing".

And last week, St. Louis Fed president James Bullard admitted he and his fellow policymakers will continue to sometimes get it dramatically wrong.

"There is only a certain amount of this that is truly forecastable and the rest is shocks. And those shocks are going to hit you and knock your economy away from your forecast."

(Reporting by Lindsay Dunsmuir; Editing by Andrea Ricci)